oversight

Bank Tying: Additional Steps Needed to Ensure Effective Enforcement of Tying Prohibitions

Published by the Government Accountability Office on 2003-10-10.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

               United States General Accounting Office

GAO            Report to the Ranking Minority Member,
               Committee on Energy and Commerce,
               House of Representatives


October 2003
               BANK TYING
               Additional Steps
               Needed to Ensure
               Effective Enforcement
               of Tying Prohibitions




GAO-04-3

               a

                                                October 2003


                                                BANK TYING

                                                Additional Steps Needed to Ensure
Highlights of GAO-04-3, a report to the         Effective Enforcement of Tying
Ranking Minority Member, the Committee
on Energy and Commerce, House of                Prohibitions
Representatives




Investment affiliates of large                  Section 106 of the Bank Holding Company Act Amendments of 1970
commercial banks have made                      prohibits commercial banks from “tying,” a practice which includes
competitive inroads in the annual               conditioning the availability or terms of loans or other credit products on the
$1.3 trillion debt-underwriting                 purchase of certain other products and services. The law permits banks to
market. Some corporate borrowers                tie credit and traditional banking products, such as cash management, and
and officials from an unaffiliated
investment bank have alleged that
                                                does not prohibit banks from considering the profitability of their full
commercial banks helped their                   relationship with customers in managing those relationships.
investment affiliates gain market
share by illegally tying and                    Some corporate customers and officials from an investment bank not
underpricing corporate credit. This             affiliated with a commercial bank have alleged that commercial banks
report discusses these allegations,             illegally tie the availability or terms, including price, of credit to customers’
the available evidence related to               purchase of other services. However, with few exceptions, formal
the allegations, and federal bank               complaints have not been brought to the attention of the regulatory agencies
regulatory agencies’ efforts to                 and little documentary evidence surrounding these allegations exists, in part,
enforce the antitying provisions.               because credit negotiations are conducted orally. Further, our review found
                                                that some corporate customers’ claims involved lawful ties between
                                                traditional banking products rather than unlawful ties. These findings
Because documentary evidence of                 illustrate a key challenge for banking regulators in enforcing this law: while
an unlawful tying arrangement                   regulators need to carefully consider the circumstances of specific
generally is not available in bank              transactions to determine whether the customers’ acceptance of an
files, GAO recommends that the                  unlawfully tied product (that is, one that is not a traditional banking
Federal Reserve and OCC consider                product) was made a condition of obtaining credit, documentary evidence
additional steps to enforce section             on those circumstances might not be available. Therefore, regulators may
106. Additional steps could include             have to look for indirect evidence to assess whether banks unlawfully tie
publication of specific contact
                                                products and services. Although customer information could have an
points within the agencies to
answer questions from banks and                 important role in helping regulators enforce section 106, regulators generally
bank customers about the guidance               have not solicited information from corporate bank customers.
in general and its application to
specific transactions, as well as to            The Board of Governors of the Federal Reserve System and the Office of the
accept complaints from bank                     Comptroller of the Currency (OCC) recently reviewed antitying policies and
customers who believe that they                 procedures of several large commercial banks. The Federal Reserve and
have been subjected to unlawful                 OCC, however, did not analyze a broadly-based selection of transactions or
tying.                                          generally solicit additional information from corporate borrowers about
                                                their knowledge of transactions. The agencies generally found no unlawful
Because low-priced credit could                 tying arrangements and concluded that these banks generally had adequate
indicate violations of law, the
                                                policies and procedures intended to prevent and detect tying practices. The
Federal Reserve should also assess
available evidence of loan pricing              agencies found variation among the banks in interpretation of the tying law
behavior to provide better                      and its exceptions. As a result, in August 2003, the Board of Governors of the
supervisory information, and                    Federal Reserve, working with OCC, released for public comment new draft
publish the results of this                     guidance, with a goal of better informing banks and their customers about
assessment.                                     the requirements of the antitying provision.
www.gao.gov/cgi-bin/getrpt?GAO-04-3.

To view the full product, including the scope
and methodology, click on the link above.
For more information, contact Richard Hillman
at (202) 512-8678 or hillmanr@gao.gov.
Contents




Letter
                                                                                               1
                             Results in Brief 
                                                       4
                             Background                                                               8

                             Some Corporate Borrowers Alleged That Unlawful Tying Occurs, 

                               but Available Evidence Did Not Substantiate These
                               Allegations                                                           15
                             Federal Reserve and OCC Targeted Review Identified Interpretive
                               Issues                                                                17
                             Evidence That We Reviewed on the Pricing of Corporate Credit Did
                               Not Demonstrate That Commercial Banks Unlawfully Discount
                               Credit                                                                25
                             Differences between Commercial Banks and Investment Banks Did
                               Not Necessarily Affect Competition                                    31
                             Conclusions                                                             39
                             Recommendations for Executive Action                                    40
                             Agency Comments                                                         40


Appendixes
              Appendix I:    Differences in Accounting between Commercial and
                             Investment Banks for Loan Commitments                                    42
                             Background                                                              
43
                             Hypothetical Scenario for Unexercised Loan Commitments 
                 45
                             Hypothetical Scenario for Exercised Loan Commitments 
                   48
             Appendix II:    Comments from the Federal Reserve System                                52
             Appendix III:   Comments from the Office of the Comptroller of the
                             Currency                                                                54
             Appendix IV:    GAO Contacts and Staff Acknowledgments                                  56
                             GAO Contacts                                                            56
                             Acknowledgments                                                         56


Tables	                      Table 1: Accounting Differences for a Loan Commitment                   48
                             Table 2: Accounting Differences for a Loan Sale                         51




                             Page i                                                  GAO-04-3 Bank Tying
Contents




Abbreviations

AICPA        American Institute of Certified Public Accountants

FASB         Financial Accounting Standards Board

FAS          Financial Accounting Standards

FDIC         Federal Deposit Insurance Corporation

OCC          Office of the Comptroller of the Currency

SEC          Securities and Exchange Commission




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Page ii                                                              GAO-04-3 Bank Tying
A

United States General Accounting Office
Washington, D.C. 20548



                                    October 10, 2003

                                    The Honorable John D. Dingell
                                    Ranking Minority Member
                                    Committee on Energy and Commerce
                                    House of Representatives

                                    Dear Mr. Dingell:

                                    In the 70 years since the passage of the Glass-Steagall Act of 1933, which
                                    prohibited commercial banks from engaging in investment banking
                                    activities such as securities underwriting, changes in legislation and
                                    regulatory interpretations have relaxed some of the restrictions imposed
                                    on bank holding companies and their subsidiaries that served to distance
                                    commercial banks from investment banking. For example, one effect of the
                                    1970 amendments to the Bank Holding Company Act of 1956 was to permit
                                    bank holding companies to own subsidiaries engaged in limited
                                    underwriting activities, but only if the subsidiary was not “principally
                                    engaged” in such activities. More recently, the Gramm-Leach-Bliley Act of
                                    1999, among other things, substantially removed that limitation. As a result
                                    of these and other developments, commercial banks and their investment
                                    bank affiliates (investment affiliates) can provide complementary financial
                                    products and services. Despite these developments, commercial banks
                                    have remained subject to certain restrictions on their activities. Among
                                    them is the prohibition against tying arrangements. In general, section 106
                                    of the Bank Holding Company Act Amendments of 1970 (section 106)
                                    prohibits banks from tying the availability or price of a product or service
                                    to a customer’s purchase of another product or service or the customer’s
                                    providing some additional credit, property or service.1

                                    In recent years, investment bank affiliates of large commercial banks have
                                    gained an increasing share of the annual $1.3 trillion debt underwriting
                                    market. A controversy has arisen over whether or not unlawful tying has
                                    contributed to this increased market share. Some unaffiliated investment
                                    banks (investment banks) and some corporate borrowers contend that
                                    commercial banks have facilitated investment affiliates’ increased market
                                    share of debt underwriting by unlawfully tying the availability of bank


                                    1
                                     As explained later, not all instances of bank tying are unlawful because certain types of
                                    products and services are not subject to the tying prohibition in the Bank Holding Company
                                    Act.




                                    Page 1                                                               GAO-04-3 Bank Tying
credit to debt underwriting by the bank’s affiliate, a violation of section 106.
In addition, some investment bankers assert that large commercial banks
engage in unlawful tying by offering reduced rates for corporate credit only
if the borrower also purchases debt underwriting services from the bank’s
investment affiliate. If such a reduced rate were conditioned only on the
borrower’s purchase of debt underwriting services from the commercial
bank’s investment affiliate, the arrangement would constitute unlawful
tying. Should the reduced rate constitute an underpricing of credit (that is,
the extension of credit below market rates), the underpricing could also
violate section 23B of the Federal Reserve Act of 1913 (section 23B).

Section 23B generally requires that certain transactions between a bank
and its affiliates occur on market terms; that is, on terms and under
circumstances that are substantially the same, or at least as favorable to
the bank, as those prevailing at the time for comparable transactions with
unaffiliated companies. Section 23B applies to any transaction by a bank
with a third party if an affiliate has a financial interest in the third party or if
an affiliate is a participant in the transaction. The banking regulators
suggest that the increase in debt underwriting market share by the
investment affiliates of large commercial banks can be explained by a
number of market and competitive factors not associated with tying, such
as industry consolidation and acquisition of investment banking firms by
bank holding companies. In addition, representatives from large
commercial banks with investment affiliates contend that they sell a range
of products and services to corporate customers, including credit, but do
not unlawfully tie bank credit or credit pricing to underwriting services.
Furthermore, officials from large commercial banks, federal banking and
securities regulators, and investment bankers observe that ties between
credit and other banking products are often customer-initiated, and thus
exempt from the laws governing tying.

To more fully examine the issues raised by the allegations about unlawful
tying and underpricing of corporate credit, you asked us to determine (1)
what evidence, if any, suggests that commercial banks with investment
affiliates engage in unlawful tying; (2) what steps the federal banking
regulators have taken to examine for unlawful tying and the results of these
efforts; (3) what evidence, if any, suggests that commercial banks with
investment affiliates unlawfully discount the price of corporate credit to
obtain underwriting business for their investment affiliates; and (4) what, if
any, competitive advantages accounting rules, capital standards, and
access to the federal safety net create for commercial banks over
investment banks.



Page 2                                                           GAO-04-3 Bank Tying
In our review of possible unlawful tying practices by large commercial
banks, we focused on wholesale corporate lending and did not address
retail banking. We conducted a legal review of section 106 of the Bank
Holding Company Act Amendments of 1970, section 23B of the Federal
Reserve Act, and relevant federal regulations, and interviewed legal experts
and academics. To describe the recent concerns about possible unlawful
tying practices, we reviewed the results of a 2003 survey on corporate
borrowers’ views about credit access conducted by the Association for
Financial Professionals and reviewed recent media coverage of tying. We
also interviewed several large corporate borrowers, and officials at several
investment banks and commercial banks with investment affiliates. We
also met with officials from NASD to discuss that organization’s Special
Notice to its members and its ongoing investigation related to tying. NASD
is a self-regulatory organization that sets and enforces market conduct
rules governing its members, which are securities firms, including those
affiliated with commercial banks.

To determine what steps the federal banking regulators have taken to
examine for unlawful tying, we reviewed the results of the Board of
Governors of the Federal Reserve System (Federal Reserve) and the Office
of Comptroller of the Currency (OCC) joint review on tying and
interviewed commercial bankers to describe the measures that large
commercial banks take to comply with the tying law. We also reviewed
federal guidance on sections 106 and 23B and Federal Reserve and OCC
examination procedures related to tying. In addition, we interviewed
officials from the Federal Reserve, OCC, and the Federal Deposit Insurance
Corporation (FDIC).

To identify possible credit pricing abuses and factors that affect overall
prices in wholesale credit markets, we interviewed commercial bankers,
credit market experts, academics experts, industry observers, and officials
at the Federal Reserve and OCC. We also reviewed economic literature on
wholesale credit markets.

To determine the accounting practices and requirements for commercial
banks and investment banks, we performed a comparative analysis of
applicable accounting standards and verified our understanding through
interviews with officials from the Financial Accounting Standards Board
(FASB), the American Institute of Certified Public Accountants (AICPA),
and the Securities and Exchange Commission (SEC). We also solicited
feedback from FASB and AICPA officials on appendix I of our draft report
and incorporated their technical comments in this report as appropriate. To



Page 3                                                    GAO-04-3 Bank Tying
                    determine the respective capital standards for commercial banks, we
                    reviewed relevant documentation and interviewed Federal Reserve, OCC,
                    and SEC officials and officials from commercial banks. We also spoke with
                    Federal Reserve and OCC officials about the access of commercial banks
                    and investment banks to the federal safety net.

                    We recognized certain limitations on the information collected during this
                    review. In particular, we recognized that much of the information provided
                    to us on selected transactions and market behavior could not be
                    independently verified. In addition, we did not independently verify the
                    results of the 2003 survey conducted by the Association for Financial
                    Professionals, which we believe are subject to methodological limitations
                    that prevent us from reporting them in detail. Nor did we verify the results
                    of the Federal Reserve and OCC’s special review targeted on tying.

                    We conducted our work in Charlotte, N.C.; Chicago, Ill.; New York, N.Y.;
                    Orlando, Fla.; and Washington, D.C., between October 2002 and October
                    2003, in accordance with generally accepted government auditing
                    standards.



Results in Brief	   Although some corporate borrowers have alleged that commercial banks
                    tie the availability or price of credit to the purchase of debt underwriting
                    services—a violation of section 106—the available evidence did not
                    substantiate these claims. Corporate borrowers could not provide
                    documentary evidence to substantiate their claims. The lack of
                    documentary evidence might be due to the fact that negotiations over
                    credit terms and conditions (during which a tying arrangement could be
                    imposed) were generally conducted orally. Borrowers also were reluctant
                    to file formal complaints with banking regulators. Reasons given for their
                    reluctance included a lack of documentary evidence of unlawful tying,
                    uncertainty about whether certain tying arrangements were illegal, and fear
                    of adverse consequences for their companies’ access to credit and for their
                    individual careers. Determining whether a tying arrangement is unlawful
                    requires close examination of the specific facts and circumstances of the
                    transactions involved, and lawful practices can easily be mistaken for
                    unlawful tying. For example, although borrowers we interviewed described
                    arrangements that could represent unlawful tying by banks, other
                    arrangements that they described involved lawful practices. Because
                    documentary evidence of unlawful tying is generally not available, banking




                    Page 4                                                     GAO-04-3 Bank Tying
regulators may have to look for other forms of indirect evidence to
effectively enforce section 106.2

Regular bank examinations in recent years have not identified any
instances of unlawful tying that led to enforcement actions.3 In response to
recent allegations of unlawful tying at large commercial banks, the Federal
Reserve and OCC conducted a joint review focused on antitying policies
and practices at several large commercial banks and their holding
companies. The review teams found that the banks generally had adequate
procedures in place to comply with section 106, and that over the past year,
some banks had made additional efforts to ensure compliance. Although
customer information could have an important role in helping the
regulators enforce section 106, regulators did not analyze a broadly based
selection of transactions or contact a broad selection of customers as part
of their review. The regulators said that they met with officials and
members from a trade group representing corporate financial executives.
The review teams questioned some transactions but generally did not find
unlawful tying arrangements. The targeted review found some variation
among banks’ interpretations of section 106, generally in areas where the
regulators have not provided authoritative guidance. As a result, the
Federal Reserve recently issued, for public comment, proposed guidance
that is intended to help banks and their customers better understand what
activities are lawful and unlawful under section 106.4 Federal Reserve
officials said that they hope this guidance also encourages customers to
come forward if they believe that they have grounds to make a complaint.




2
 For purposes of this report, the term “indirect evidence” refers to information that is not
contained in transaction documents maintained by the bank. Section 106 is codified at 12
U.S.C.§ 1972 (2000).
3
 After the Federal Reserve and OCC completed the targeted review, the Federal Reserve
announced on August 27, 2003, that it had entered into a consent agreement and civil money
penalty against WestLB AG, a German bank, and its New York branch, based on allegations
that in 2001 it conditioned the availability of credit on the borrower’s obtaining underwriting
business from a WestLB affiliate.
4
 68 Fed. Reg. 52024 (Aug. 29, 2003). OCC released a white paper, “Today’s Credit Markets,
Relationship Banking, and Tying,” on September 25, 2003, which discussed banks’ market
power and economic performance for evidence of tying, the market competitiveness of
diversified banking organizations, and relationship banking. The paper concluded that the
relationship banking practices, as described in the white paper, are consistent with the
relevant legal framework.




Page 5                                                                   GAO-04-3 Bank Tying
Although officials from one investment bank alleged that the pricing of
some corporate credit by large commercial banks was a factor in violations
of section 106 and possibly section 23B, we found that the available
evidence on pricing was subject to multiple interpretations and did not
necessarily demonstrate violations of either section 106 or section 23B.
Some investment banks contended that large commercial banks
deliberately underpriced corporate credit to attract underwriting business
to their investment affiliates. Section 106 prohibits a bank from setting or
varying the terms of credit on the condition that the customer purchase
certain other products and services from the bank or an affiliate, unless
those products and services (such as traditional banking services) are
exempted from the prohibition. If the price of the credit is less than the
market price and the bank’s investment affiliate is a participant in the
transaction, then the transaction would reduce the bank’s income for the
benefit of its affiliate, and thus be in violation of section 23B.5 However, our
review of specific transactions cited by an investment bank found the
available evidence of underpricing to be ambiguous and subject to different
interpretations. During the course of our review, Federal Reserve staff said
that they were considering whether to conduct a research study of pricing
issues in the corporate loan market. Such a study could improve the
regulators’ ability to determine if transactions are conducted at prices that
were not determined by market forces.

Although officials at one investment bank also contended that differences
in accounting conventions, regulatory capital requirements, and access to
the federal safety net provide a competitive advantage that enables
commercial banks with investment affiliates to underprice loan
commitments, we found that these differences did not appear to provide a
clear and consistent competitive advantage for commercial banks.

•	 Because commercial banks are not permitted by the accounting
   standards to recognize changes in the value of loans and loan
   commitments compared with current market prices while investment
   banks recognize these changes in their net income, officials at some
   investment banks have contended that accounting standards give
   commercial banks a competitive advantage. However, FASB, which sets
   private-sector financial accounting and reporting standards, noted that
   commercial banks and investment banks follow different accounting
   models for these transactions. Based on our analysis, banks’ adherence


5
See 12 U.S.C.§ 371c-1 (2000).




Page 6                                                        GAO-04-3 Bank Tying
   to different accounting rules caused a temporary difference in the
   recognition of the service fees from short-term loan commitments—a
   difference that appeared to be relatively small compared with revenue
   from other bank activity and would be resolved by the end of the loan
   commitment period. Moreover, both commercial banks and investment
   banks must report the fair value of loan commitments in the footnotes
   of their financial statements. Further, we found that if the loan
   commitment were exercised and both firms either had the intent and
   ability to hold the loan for the foreseeable future or until maturity, or
   made the loan available for sale, the accounting would be similar and
   would not provide an advantage to either firm.

•	 Additionally, while commercial and investment banks were subject to
   different regulatory capital requirements, practices of both commercial
   and investment banks led to avoidance of regulatory charges on loan
   commitments with a maturity of 1 year or less. Officials from one
   investment bank also contended that bank regulatory capital
   requirements gave commercial banks a competitive advantage in
   lending because they are not required to hold regulatory capital against
   short-term unfunded loan commitments. In comparison, investment
   banks could face a 100-percent regulatory capital charge if they carried
   loan commitments in their broker-dealer affiliates. However, in practice,
   investment bankers told us that they generally carry loan commitments
   outside of their broker-dealer affiliates and thus also avoid regulatory
   capital charges.

•	 Some officials from investment banks also contended that commercial
   banks’ access to the federal safety net, including access to federal
   deposit insurance and Federal Reserve discount window lending, gives
   the banks a further cost advantage. However, industry observers and
   OCC officials said that this subsidy is likely offset by regulatory costs.

This report includes a recommendation that the Federal Reserve and the
OCC consider taking additional steps to ensure effective enforcement of
section 106 and section 23B, including enhancing the information that they
receive from corporate borrowers. For example, the agencies could
develop a communication strategy that is directed at a broad audience of
corporate bank customers to enhance their understanding of section 106.
Because low priced credit could indicate a potential violation of section
23B, we also recommend that the Federal Reserve assess available
evidence regarding loan pricing behavior, and if appropriate, conduct
additional research to better enable examiners to determine whether



Page 7                                                      GAO-04-3 Bank Tying
                              transactions are conducted on market terms, and that the Federal Reserve
                              publish the results of this assessment.



Background	                   Large banking organizations typically establish ongoing relationships with
                              their corporate customers and evaluate the overall profitability of these
                              relationships. They use company-specific information gained from
                              providing certain products and services—such as credit or cash
                              management—to identify additional products and services that customers
                              might purchase. This practice, known as “relationship banking,” has been
                              common in the financial services industry for well over a century.

                              In recent years, as the legal and regulatory obstacles that limited banking
                              organizations’ abilities to compete in securities and insurance activities
                              have been eased, some large banking organizations have sought to expand
                              the range of products and services they offer customers. In particular, some
                              commercial banks have sought to decrease their reliance on the income
                              earned from credit products, such as corporate loans, and to increase their
                              reliance on fee-based income by providing a range of priced services to
                              their customers.



Federal Banking Regulators	   The Federal Reserve and OCC are the federal banking regulators charged
                              with supervising and regulating large commercial banks. The Federal
                              Reserve has primary supervisory and regulatory responsibilities for bank
                              holding companies and their nonbank and foreign subsidiaries and for
                              state-chartered banks that are members of the Federal Reserve System and
                              their foreign branches and subsidiaries. The Federal Reserve also has
                              regulatory responsibilities for transactions between member banks and
                              their affiliates. OCC has primary supervisory and regulatory
                              responsibilities for the domestic and foreign activities of national banks
                              and their subsidiaries. OCC also has responsibility for administering and
                              enforcing standards governing transactions between national banks and
                              their affiliates. Among other activities, the Federal Reserve and OCC
                              conduct off-site reviews and on-site examinations of large banks to provide
                              periodic analysis of financial and other information, provide ongoing
                              supervision of their operations, and determine compliance with banking
                              laws and regulations. Federal Reserve and OCC examinations are intended
                              to assess the safety and soundness of large banks and identify conditions
                              that might require corrective action.




                              Page 8                                                    GAO-04-3 Bank Tying
Section 106 of the Bank   Congress added section 106 to the Bank Holding Company Act in 1970 to
Holding Company Act       address concerns that an expansion in the range of activities permissible
                          for bank holding companies might give them an unfair competitive
Amendments of 1970        advantage because of the unique role their bank subsidiaries served as
                          credit providers.6 Section 106 makes it unlawful, with certain exceptions,
                          for a bank to extend credit or furnish any product or service, or vary the
                          price of any product or service (the “tying product”) on the “condition or
                          requirement” that the customer obtains some additional product or service
                          from the bank or its affiliate (the “tied product”).7 Under section 106, it
                          would be unlawful for a bank to provide credit (or to vary the terms for
                          credit) on the condition or requirement that the customer obtain some
                          other product from the bank or an affiliate, unless that other product was a
                          traditional bank product.8 Thus, it would be unlawful for a bank to
                          condition the availability or pricing of new or renewal credit on the
                          condition that the borrower purchase a nontraditional bank product from
                          the bank or an affiliate.

                          In contrast, section 106 does not require a bank to extend credit or provide
                          any other product to a customer, as long as the bank’s decision was not
                          based on the customer’s failure to satisfy a condition or requirement
                          prohibited by section 106. For example, it would be lawful for a bank to
                          deny credit to a customer on the basis of the customer’s financial
                          condition, financial resources, or credit history, but it would be unlawful
                          for a bank to deny credit because the customer failed to purchase
                          underwriting services from the bank’s affiliate.




                          6
                          See, e.g., H.R. Conf. Rep. No. 91-1747, reprinted in 1970 U.S.C.A.N. 5561, 5569.
                          7
                           Section 106 also prohibits reciprocity and exclusive dealing arrangements. Reciprocity
                          arrangements are arrangements that require a customer to provide some credit, property, or
                          service to the bank or one of its affiliates as a condition of the bank providing another
                          product to the customer. Exclusive dealing arrangements are arrangements that require a
                          customer not to obtain some other credit, property, or service from a competitor of the bank
                          or its affiliate as a condition of the bank providing another product to the customer. The
                          allegations we encountered during our work did not involve such arrangements.
                          8
                           A key exception to section 106 is that banks may condition the price or availability of a
                          service or product on the basis of a customer obtaining a “traditional bank product,” which
                          the section defines as “a loan, discount, deposit, or trust service.” Section 106 provides this
                          exception only with respect to traditional bank products offered by the bank, but the Board
                          has extended the exception to include traditional bank products offered by an affiliate of the
                          bank. 12 C.F.C. § 225.7(b)(1) (2003)).




                          Page 9                                                                   GAO-04-3 Bank Tying
Section 106 does not prohibit a bank from cross-marketing products that
are not covered by the “traditional banking product” exemption or from
granting credit or providing any other product or service to a customer
based solely on the hope that the customer obtain additional products from
the bank or its affiliates in the future, provided that the bank does not
require the customer to purchase an additional product. Also, section 106
generally does not prohibit a bank from conditioning its relationship with a
customer on the total profitability of its relationship with the customer.

Section 106 authorizes the Federal Reserve to make exceptions that are not
contrary to the purposes of the tying prohibitions. The Federal Reserve has
used this authority to allow banks to offer broader categories of packaging
arrangements, where it has determined that these arrangements benefit
customers and do not impair competition. In 1971, the Federal Reserve
adopted a regulation that extended antitying rules to bank holding
companies and their nonbank affiliates and approved a number of
nonbanking activities that these entities could engage in under the Bank
Holding Company Act. Citing the competitive vitality of the markets in
which nonbanking companies generally operate, in February 1997, the
Federal Reserve rescinded this regulatory extension.9 At the same time, the
Federal Reserve expanded the traditional bank products exception to
include traditional bank products offered by nonbank affiliates.

In the mid-1990s, the Board also added two regulatory safe harbors. First,
the Board granted a regulatory safe harbor for combined-balance discount
packages, which allowed a bank to vary the consideration for a product or
package of products—based on a customer’s maintaining a combined
minimum balance in certain products—as long as the bank offers deposits,
the deposits are counted toward the combined-balance, and the deposits
count at least as much as nondeposit products toward the minimum
balance.10 Furthermore, according to the Board, under the combined-
balance safe harbor, the products included in the combined balance
program may be offered by either the bank or an affiliate, provided that the
bank specifies the products and the package is structured in a way that
does not, as a practical matter, obligate a customer to purchase
nontraditional bank products to obtain the discount. Second, the Board
granted a regulatory safe harbor for foreign transactions. This safe harbor


9
See 83 Fed. Res. Bulletin 275 (April 1997).
10
     Id.




Page 10                                                   GAO-04-3 Bank Tying
                              provides that the antitying prohibitions of section 106 do not apply to
                              transactions between a bank and a customer if the customer is a company
                              that is incorporated, chartered, or otherwise organized outside of the
                              United States, and has its principal place of business outside of the United
                              States, or if the customer is an individual who is a citizen of a country other
                              than the United States and is not resident in the United States.11



Violations of Section 106 	   On August 29, 2003, the Board published for public comment its proposed
                              interpretation and supervisory guidance concerning section 106.12 In this
                              proposed interpretation, the Federal Reserve noted that determining
                              whether a violation of section 106 occurred requires a detailed
                              understanding of the facts underlying the transaction in question. In this
                              proposed interpretation, the Federal Reserve also noted what it considers
                              to be the two key elements of a violation of section 106:

                                         (1) The arrangement must involve two or more separate products: the
                                         customer’s desired product(s) and one or more separate tied products;
                                         and

                                         (2) The bank must force the customer to obtain (or provide) the tied
                                         product(s) from (or to) the bank or an affiliate in order to obtain the
                                         customer‘s desired product(s) from the bank.13

                              A transaction does not violate section 106 unless it involves two separate
                              products or services. For example, a bank does not violate section 106 by
                              requiring a prospective borrower to provide the bank specified collateral to
                              obtain a loan or by requiring an existing borrower to post additional
                              collateral as a condition for renewing a loan. Assuming two products or
                              services are involved, the legality of the arrangement depends on, among


                              11
                                   Id.
                              12
                                   68 Fed. Reg. 52024 (August 29, 2003).
                              13
                               68 Fed. Reg. at 52027. A tie exists under section 106 if the bank furnishes the tying product
                              “on the condition or requirement” that the customer obtain the tied product or provide some
                              additional credit, property or service. In its guidance, the Board stated that even if a
                              condition or requirement exists, further inquiry might be necessary because the condition or
                              requirement violates section 106 only if it resulted from coercion by the bank. Id. at 52028.
                              As the Board recognized, however, some courts have held that a tying arrangement may
                              violate section 106 without a showing that the arrangement resulted from any type of
                              coercion by the bank. Id. at 52029, n. 36.




                              Page 11                                                                 GAO-04-3 Bank Tying
other things, which products and services are involved and in what
combinations. It would be unlawful for a bank to condition the availability
of corporate credit on a borrower’s purchase of debt underwriting services
from its affiliate, because a bank cannot condition the availability of a bank
product on a customer’s purchase of a nontraditional product or service.
According to the Board’s proposed interpretation, a bank can legally
condition the availability of a bank product, such as credit, on the
customer’s selection from a mix of traditional and nontraditional products
or services—a mixed-product arrangement—only if the bank offered the
customer a “meaningful choice” of products that includes one or more
traditional bank products and did not require the customer to purchase any
specific product or service. For example, according to the Federal Reserve,
a bank could legally condition the availability of credit on a customer’s
purchase of products from a list of products and services that includes debt
underwriting and cash management services, provided that this mixed-
product arrangement contained a meaningful option to satisfy the bank’s
condition solely through the purchase of the traditional bank products
included in the arrangement. However, it would be a violation of section
106 for a bank to condition the availability of credit on a mixed-product
arrangement that did not contain a meaningful option for the customer to
satisfy the bank’s condition solely through the purchase of a traditional
bank product.

When a bank offers a customer a low price on credit, it might or might not
be a violation of law. If a bank reduced the cost of credit on the condition
that the customer purchase nontraditional bank products or services
offered by its investment affiliate, this arrangement would violate section
106. However, if a bank offered a low price on credit to attract additional
business but did not condition the availability of the price on the purchase
of a prohibited product, it would not violate section 106. Additionally, if a
reduced interest rate were to constitute underpricing of a loan, such a
transaction, depending on the circumstances, could violate section 23B of
the Federal Reserve Act of 1913, which we discuss later in this section.

Whether the arrangement constitutes an unlawful tie under section 106 also
depends upon whether a condition or requirement actually exists and
which party imposes the condition or requirement. Determining the
existence of either element can be difficult. The question of whether a
condition or requirement exists is particularly difficult because of
uncertainties about how to interpret that aspect of the prohibition.
According to the Board’s proposal, section 106 applies if two requirements
are met: “(1) a condition or requirement exists that ties the customer’s



Page 12                                                     GAO-04-3 Bank Tying
desired product to another product; and (2) this condition or requirement
was imposed or forced on the customer by the bank.”14 Thus, according to
the Board’s proposal, if a condition or requirement exists, further inquiry
may be necessary to determine whether the condition or requirement was
imposed or forced on the customer by the bank: “If the condition or
requirement resulted from coercion by the bank, then the condition or
requirement violates section 106, unless an exemption is available for the
transaction.”15 This interpretation is not universally accepted, however. As
the Board’s proposal has noted, some courts have held that a tying
arrangement violates section 106 without a showing that the arrangement
resulted from any type of coercion by the bank.16 Uncertainties about the
proper interpretation of the “condition or require” provision of section 106
have lead to disagreement over the circumstances that violate section 106.

It has been suggested that changes in financial markets that have occurred
since the enactment of section 106, particularly a decreased corporate
reliance on commercial bank loans, also are relevant in considering
whether banks currently can base credit decisions on a “condition or
requirement” that corporate customers buy other services. At the end of
1970, according to the Federal Reserve’s Flow of Funds data, bank loans
accounted for about 24 percent of the total liabilities of U.S. nonfarm,
nonfinancial corporations. At the end of 2002, bank loans accounted for
about 14 percent of these liabilities.

Because section 106 applies only to commercial and savings banks,
investment banks and insurance companies, which compete in credit
markets with banks, are not subject to these tying restrictions.17 Thus,
under section 106, a bank’s nonbank affiliate legally could condition the
availability of credit from that nonbank affiliate on a customer’s purchase
of debt underwriting services. Where a transaction involves a bank as well
as one or more affiliates, uncertainties could exist over whether the


14
     68 Fed. Reg. at 52028.
15
     Id. at 52029.
16
     Id., n. 36.
17
 Thrifts are subject to a similar antitying prohibition. Section 5(q) of the Home Owners
Loan Act, 12 U.S.C. § 1464(q) (2000) places restrictions on savings associations that are
almost identical to those placed on banks by section 106, although the Office of Thrift
Supervision may only grant exceptions to section 5(q) that conform to exceptions to section
106 granted by the Board.




Page 13                                                               GAO-04-3 Bank Tying
                              affiliate or the bank imposed a condition or requirement. It should be
                              noted, however, that all of these financial institutions are subject to the
                              more broadly applicable antitrust laws, such as the Sherman Act, that
                              prohibit anticompetitive practices, including tying arrangements.18 In
                              addition, under section 106 it is lawful for bank customers to initiate ties.
                              For example, a customer could use its business leverage to obtain
                              favorable credit terms or require a bank to extend a corporate loan as a
                              condition for purchasing debt underwriting services.



Section 23B of the Federal    Section 23B requires that transactions involving a bank and its affiliates,
Reserve Act of 1913           including those providing investment-banking services, be on market
                              terms.19 Although section 106 generally prohibits changing the price for
Prohibits Transactions That
                              credit on the condition that the customer obtain some other services from
Benefit Bank Affiliates at    the bank or its affiliates, section 23B prohibits setting the price for credit at
the Expense of the Bank       a below-market rate that would reduce the bank’s income for the benefit of
                              its affiliate. Banking regulators have noted that pricing credit at below-
                              market rates could also be an unsafe and unsound banking practice
                              independent of whether the practice violates section 23B specifically.




                              18
                                 As the Board observed in its proposed interpretation and guidance, as a general matter, a
                              tying arrangement violates the Sherman Act (15 U.S.C. §§ 1-7 (2000)) and the Clayton Act
                              (15 U.S.C. §§ 12-27 (2000)) if (1) the arrangement involves two or more products, (2) the
                              seller forces a customer to purchase the tied product, (3) the seller has economic power in
                              the market for the tying product sufficient to enable the seller to restrain trade in the market
                              for the tied product, (4) the arrangement has anticompetitive effects in the market for the
                              tied product, and (5) the arrangement affects a “not insubstantial” amount of interstate
                              commerce. See 68 Fed. Reg. at 52027, n. 20.
                              19
                                In October 2002, the Federal Reserve Board approved Regulation W, which
                              comprehensively implements and unifies the Board’s interpretations of sections 23A and
                              23B of the Federal Reserve Act. Regulation W became effective in April 2003, and restricts
                              loans by a depository institution to its affiliates, asset purchases by a depository institution
                              from its affiliates, and other transactions between a depository institution and its affiliates.




                              Page 14                                                                   GAO-04-3 Bank Tying
Some Corporate                Some corporate borrowers alleged that commercial banks unlawfully tie
                              the availability of credit to the borrower’s purchase of other financial
Borrowers Alleged             services, including debt underwriting services from their banks’ investment
That Unlawful Tying           affiliates. Because banks, in certain circumstances, may legally condition
                              the availability of credit on the borrower’s purchase of other products,
Occurs, but Available         some of these allegations of unlawful tying could be invalid. Substantiating
Evidence Did Not              charges of unlawful tying, if it occurs, can be difficult because, in most
Substantiate These            cases, credit negotiations are conducted orally and thus generate no
                              documentary evidence to support borrowers’ allegations. Thus, banking
Allegations                   regulators may have to obtain other forms of indirect evidence to assess
                              whether banks unlawfully tie products and services. Although customer
                              information could have an important role in helping regulators enforce
                              section 106, regulators do not have a specific mechanism to solicit
                              information from corporate bank customers on an ongoing basis.



Some Corporate Borrowers      The results of a 2003 survey of financial executives, interviews that we
Contended That Banks          conducted with corporate borrowers, and several newspaper articles,
                              suggest that commercial banks frequently tie access to credit to the
Unlawfully Forced Them to
                              purchase of other financial services, including bond underwriting, equity
Purchase Additional           underwriting, and cash management.20 The Association for Financial
Services to Preserve Access   Professionals reported that some respondents to their survey of financial
to Credit                     executives at large companies (those with revenues greater than $1 billion)
                              claimed to have experienced the denial of credit or a change in terms after
                              they did not award a commercial bank their bond underwriting business. In
                              our interviews with corporate borrowers, one borrower said that a
                              commercial bank reduced the borrower’s amount of credit by $70 million
                              when the borrower declined to purchase debt underwriting services from
                              the bank’s investment affiliate. In addition, several newspapers and other
                              publications have also reported instances where corporate borrowers have
                              felt pressured by commercial banks to purchase products prohibited under
                              section 106 for the customers to maintain their access to credit. In these


                              20
                                We did not report the specific results of the Association for Financial Professionals’
                              “Credit Access Survey: Linking Corporate Credit to the Awarding of Other Financial
                              Services,” March 2003, because of several methodological limitations. In particular, we
                              could not determine the degree to which these survey results represent the broad
                              population of large companies, due to potential biases resulting from sample design and the
                              low level of participation of sampled companies. Nevertheless, although this survey may not
                              precisely estimate the extent of tying complaints among this population, the results suggest
                              that at least some companies claimed to have experienced forms of tying.




                              Page 15                                                                GAO-04-3 Bank Tying
                              reports, corporate borrowers have described negotiations where, in their
                              views, bankers strongly implied that future lending might be jeopardized
                              unless they agreed to purchase additional services, such as underwriting,
                              from the banks’ investment affiliates. However, none of these situations
                              resulted in the corporate borrower complaining to one of the banking
                              regulators.

                              In its Special Notice to its members, NASD also noted the Association for
                              Financial Professional survey. The notice cautioned that NASD regulations
                              require members to conduct business in accordance with just and equitable
                              principles of trade and that it could be a violation of these rules for any
                              member to aid and abet a violation of section 106 by an affiliated
                              commercial bank. NASD is conducting its own investigation into these
                              matters. At the time of our review, NASD had not publicly announced any
                              results of its ongoing investigation.



Lawful Practices Can Easily   Corporate borrowers might be unaware of the subtle distinctions that make
Be Mistaken for Unlawful      some tying arrangements lawful and others unlawful. Borrowers, officials
                              at commercial banks, and banking regulators said that some financial
Tying Practices               executives might not be familiar with the details of section 106. For
                              example, some borrowers we interviewed thought that banks violated the
                              tying law when they tied the provision of loan commitments to borrowers’
                              purchases of cash management services. However, such arrangements are
                              not unlawful, because, as noted earlier, section 106 permits banks to tie
                              credit to these and other traditional bank services. The legality of tying
                              arrangements might also hinge on the combinations of products that the
                              borrowers are offered. For example, recently proposed Federal Reserve
                              guidance suggested that a bank could legally condition the availability of
                              credit on the purchase of other products services, including debt
                              underwriting, if the customer has the meaningful choice of satisfying the
                              condition solely through the purchase of one or more additional traditional
                              bank products.21




                              21
                               The proposed guidance noted that such an arrangement would not force a customer to
                              purchase a nontraditional product in violation of section 106.




                              Page 16                                                           GAO-04-3 Bank Tying
Corporate Borrowers Could   Corporate borrowers said that because the credit arrangements are made
Not Provide Documentary     orally, they lack the documentary evidence to demonstrate unlawful tying
                            arrangements in those situations where they believe it has occurred.
Evidence to Substantiate    Without such documentation, borrowers might find it difficult to
Allegations of Unlawful     substantiate such claims to banking regulators or seek legal remedies.
Tying                       Moreover, with few exceptions, complaints have not been brought to the
                            attention of the banking regulators. Some borrowers noted that they are
                            reluctant to report their banks’ alleged unlawful tying practices because
                            they lack documentary evidence of such arrangements and uncertainty
                            about which arrangements are lawful or unlawful under section 106.
                            Borrowers also noted that a fear of adverse consequences on their
                            companies’ future access to credit or on their individual careers
                            contributed to some borrowers’ reluctance to file formal complaints.
                            Because documentary evidence demonstrating unlawful tying might not be
                            available in bank records, regulators might have to look for other forms of
                            indirect evidence, such as testimonial evidence, to assess whether banks
                            unlawfully tie products and services.



Federal Reserve and         The guidance that the federal banking regulators have established for their
                            regular examinations of banks calls for examiners to be alert to possible
OCC Targeted Review         violations of law, including section 106. These examinations generally
Identified Interpretive     focus on specific topics based on the agencies’ assessments of the banks’
                            risk profiles, and tying is one of many possible topics. In response to recent
Issues                      allegations of unlawful tying at large commercial banks, the Federal
                            Reserve and OCC conducted a special targeted review of antitying policies
                            and procedures at several large commercial banks and their holding
                            companies. The banking regulators focused on antitying policies and
                            procedures; interviewed bank managers responsible for compliance,
                            training, credit pricing, and internal audits; and reviewed credit pricing
                            policies, relationship banking policies, and the treatment of customer
                            complaints regarding tying. The review did not include broadly based
                            testing of transactions that included interviews with corporate borrowers.
                            The regulators said that they met with officials and members of a trade
                            group representing corporate financial executives. The banking regulators
                            found that banks covered in the review generally had adequate controls in
                            place. With limited exceptions, they did not detect any unlawful
                            combinations or questionable transactions. The examiners did, however,
                            identify variation among the banks in interpreting section 106, some of
                            which was not addressed in the regulatory guidance then available. As a
                            result of the findings of the special targeted review, on August 29, 2003, the



                            Page 17                                                     GAO-04-3 Bank Tying
                              Federal Reserve released for public comment proposed guidance to clarify
                              the interpretation of section 106 for examiners, bankers, and corporate
                              borrowers. Federal Reserve officials said that they hope that the guidance
                              encourages customers to come forward if they have complaints.



Tying Is a Component of       As part of their routine examination procedures, the Federal Reserve and
Guidelines for Regular Bank   OCC provide instructions for determining compliance with section 106.22
                              During the course of these examinations, examiners review banks’ policies,
Examinations
                              procedures, controls, and internal audits. Exam teams assigned to the
                              largest commercial banks continually review banks throughout the year,
                              and in several cases, the teams are physically located at the bank
                              throughout the year. The Federal Reserve and OCC expect examiners to be
                              alert to possible violations of section 106 of the Bank Holding Company Act
                              Amendments of 1970 and section 23B of the Federal Reserve Act and to
                              report any evidence of possible unlawful tying for further review. Regular
                              bank examinations in recent years have not identified any instances of
                              unlawful tying that led to enforcement actions. Federal Reserve officials
                              told us, however, that if an examiner had tying-related concerns about a
                              transaction that the bank’s internal or external legal counsel had reviewed,
                              examiners deferred to the bank’s legal analysis and verified that the bank
                              took any appropriate corrective actions. Federal Reserve officials also said
                              that legal staffs at the Board and the District Reserve Banks regularly
                              receive and answer questions from examiners regarding the permissibility
                              of transactions.

                              In a 1995 bulletin, OCC reminded national banks of their obligations under
                              section 106 and advised them to implement appropriate systems and
                              controls that would promote compliance with section 106.23 Along with
                              examples of lawful tying arrangements, the guidance also incorporated
                              suggested measures for banks’ systems and controls, and audit and
                              compliance programs. Among the suggested measures were training bank
                              employees about the tying provisions, providing relevant examples of
                              prohibited practices, and reviewing customer files to determine whether



                              22
                               For example, Federal Reserve Board Supervision Manuals governing bank holding
                              company and state member bank examinations and OCC Bulletin 95-20 all address section
                              106.
                              23
                                   OCC Bulletin 95-20 (April 14, 1995).




                              Page 18                                                           GAO-04-3 Bank Tying
                            any extension of credit was conditioned unlawfully on obtaining another
                            nontraditional product or service from the bank or its affiliates.

                            In addition to reviewing banks’ policies, procedures, and internal controls,
                            examiners also review aggregate data on a bank’s pricing of credit
                            products. OCC officials noted that instances of unlawfully priced loans or
                            credit extended to borrowers who were not creditworthy could alert
                            examiners to potential unlawful tying arrangements. However, Federal
                            Reserve officials pointed out that examiners typically do not focus on a
                            banks’ pricing of individual transactions because factors that are unique to
                            the bank and its relationship with the customer affect individual pricing
                            decisions. They said that examiners only conduct additional analyses if
                            there was an indication of a potential problem within the aggregated data.



Examiners Generally Found   In recent years, banking regulators’ examination strategies have moved
Adequate Bank Controls      toward a risk-based assessment of a bank’s policies, procedures, and
                            internal controls, and away from the former process of transaction testing.
and No Unlawful Tying
                            The activities judged by the regulatory agencies to pose the greatest risk to
during a Special Review     a bank are to receive the most scrutiny by examiners under the risk-based
                            approach, and transaction testing is generally intended to validate the use
                            and effectiveness of risk-management systems. The effectiveness of this
                            examination approach, however, depends on the regulators’ awareness of
                            risk. In the case of tying, the regulators are confronted with the disparity
                            between frequent allegations about tying practices and few, if any, formal
                            complaints. Further, the examiners generally would not contact customers
                            as part of the examinations and thus would have only limited access to
                            information about transactions or the practices that banks employ in
                            managing their relationships with customers.

                            In response to the controversy about allegations of unlawful tying, in 2002
                            the Federal Reserve and OCC conducted joint reviews targeted to assessing
                            antitying policies and procedures at large commercial banks that,
                            collectively, are the dominant syndicators of large corporate credits. The
                            Federal Reserve and OCC exam teams found limited evidence of
                            potentially unlawful tying in the course of the special targeted review.24 For


                            24
                               After the Federal Reserve and OCC completed the targeted review, the Federal Reserve
                            announced on August 27, 2003, that it had entered into a consent agreement and civil money
                            penalty against WestLB AG, a German bank, and its New York branch, based on allegations
                            that it had conditioned credit on the award of underwriting business in 2001.




                            Page 19                                                              GAO-04-3 Bank Tying
example, one bank’s legal department uncovered one instance where an
account officer proposed an unlawful conditional discount. The officer
brought this to the attention of the legal department after the officer
attended antitying training. The customer did not accept the offer, and no
transaction occurred.

In addition, the teams noted that the commercial bank’s interpretation of
section 106 permitted some activities that the teams questioned; one of the
banks reversed a transaction in response to examiner questions. Attorneys
on the exam teams reviewed documents regarding lawsuits alleging
unlawful tying, but they found that none of the suits contained allegations
that warranted any follow-up. For example, they found that some of the
suits involved customers who were asserting violations of section 106 as a
defense to the bank’s efforts to collect on loans and that some of the ties
alleged in the suits involved ties to traditional bank products, which are
exempted from section 106.

Federal Reserve and OCC officials noted that it would be unusual to find a
provision in a loan contract or other loan documentation containing an
unlawful tie. Some corporate borrowers said that there is no documentary
evidence because banks only communicate such conditions on loans orally.
According to members of the review team, they did not sample
transactions during the review because past reviews suggested that this
would probably not produce any instances of unlawful tying practices. The
targeted review did include contacting some bank customers to obtain
information on specific transactions. The Federal Reserve noted that
without examiners being present during credit negotiations, there is no
way for examiners to know what the customer was told. Given the complex
nature of these transactions, the facts and circumstances could vary
considerably among individual transactions. Federal Reserve officials,
however, noted that customer information could play an important role in
enforcing the law, because so much depends on whether the customer
voluntarily agreed with the transaction or was compelled to agree with the
conditions imposed by the bank. As the officials noted, this determination
cannot be made based solely on the loan documentation.

During the targeted review, Federal Reserve and OCC officials found that
all of the banks they reviewed generally had adequate procedures in place
to comply with section 106. All banks had specific antitying policies,
procedures, and training programs in place. The policies we reviewed from
two banks encouraged employees to consult legal staff for assistance with
arrangements that could raise a tying-related issue. According to the



Page 20                                                   GAO-04-3 Bank Tying
Federal Reserve and OCC, at other banks, lawyers reviewed all
transactions for tying-related issues before they were completed. The
training materials we reviewed from two banks included examples that
distinguished lawful from unlawful tying arrangements. Banking regulators
noted that some banking organizations had newly enhanced policies,
procedures, and training programs as a result of recent media and
regulatory attention.

However, examiners also found that the oversight by internal audit
functions at several banks needed improvement. In one case, they found
that bank internal auditors were trained to look for the obvious indications
of tying, but that banks’ audit procedures would not necessarily provide a
basis to detect all cases of tying. For example, recent antitying training
programs at two banks helped employees identify possible tying violations.
Officials at one large banking organization also said that banks’ compliance
efforts generally are constrained by the inability to anticipate every
situation that could raise tying concerns. They also noted that banks could
not monitor every conversation that bank employees had with customers,
and thus guarantee that mistakes would never occur.

In addition, examiners were concerned that certain arrangements might
cause customer confusion when dealing with employees who work for
both the bank and its investment affiliate. In those cases, it could be
difficult to determine whether the “dual” employee was representing the
bank or its affiliate for specific parts of a transaction. However, the
examiners noted that in the legal analysis of one banking organization, the
use of such dual employees was not necessarily problematic, given that the
tie was created by the investment affiliate, rather than the bank, and that
section 106 addresses the legal entity involved in a transaction and not the
employment status of the individuals involved. Proposed Federal Reserve
guidance did not add clarification to this matter beyond emphasizing the
importance of training programs for bank employees as an important
internal control.

The targeted review concluded that the policies and procedures of the
selected banks generally provided an adequate basis to enforce compliance
with section 106, and identified only a limited number of instances where
the bank’s interpretation of the law permitted actions that were questioned
during the review. However, this targeted review was limited to an
assessment of the banks’ controls environment; and as noted above, the
review did not test a broad range of transactions for analysis or review and
did not include any questions addressed to a broad selection of bank



Page 21                                                   GAO-04-3 Bank Tying
                          customers. As the Federal Reserve’s proposed interpretation of section 106
                          notes, however,

                          “the determination of whether a violation of section 106 has occurred often requires a
                          careful review of the specific facts and circumstances associated with the relevant
                          transaction (or proposed transaction) between the bank and the customer.”25

                          Customers could provide information on the facts and circumstances
                          associated with specific transactions and provide a basis for testing
                          whether the bank actions were in compliance with its policies and
                          procedures. If the banks’ actions are not consistent with their policies and
                          procedures, there could be violations of section 106. A review of the
                          transactions would provide direct evidence of compliance or
                          noncompliance with section 106. Further, information from analysis of
                          transactions and information obtained from customers could provide the
                          bank regulatory agencies with more information on the circumstances
                          where there could be a greater risk of tying, contributing to their risk-based
                          examination strategies.



Federal Reserve and OCC   The examiners and attorneys participating in the targeted review found
Identified Several        variations in banks’ interpretation of section 106 in areas where
                          authoritative guidance was absent or incomplete at the time of the review.
Interpretive Issues
                          One interpretative issue was the extent to which a bank could consider the
                          profitability of the overall customer relationship in making credit
                          decisions, particularly whether a bank could consider a customer’s use of
                          nontraditional banking services in deciding to terminate the customer
                          relationship without violating section 106. This issue also encompassed the
                          appropriateness of the language that a bank might use when entering into
                          or discontinuing credit relationships—including whether a bank could
                          appropriately use language implying the acceptance of a tied product in a
                          letter formalizing a commitment for a loan and communication protocols
                          that a bank might use to disengage clients who did not meet internal
                          profitability targets.

                          Examiners found that all banks in the joint targeted review had undergone
                          a “balance sheet reduction,” disengaging from lending relationships with
                          their least desirable customers. An official at one commercial bank


                          25
                               38 Fed. Reg. at 52026.




                          Page 22                                                                GAO-04-3 Bank Tying
acknowledged that, when banks discontinue relationships, their decision
might appear to be unlawful tying from the perspective of the customer.
However, it would not be unlawful for a bank to decline to provide credit to
a customer as long as the bank’s decision was not based on the customer’s
failure to satisfy a condition or requirement prohibited by section 106.

Examiners questioned whether it would be appropriate for a banking
organization to provide both a bridge loan and securities underwriting to
vary the amount of fees it charged for services that would normally be done
independently for each service.26 For example, a bank conducting a credit
analysis for both commercial and investment banking services and
reducing the overall fees to only include one credit analysis might raise
tying considerations. Banks and their outside counsels believed that this
price reduction would be appropriate. However, the Federal Reserve staff
said that whether or not a price reduction would be appropriate would
depend on the facts and condition of the transaction, including whether or
not the bank offered the customer the opportunity to obtain the discount
from the bank separately from the tied product.

Examiners were also concerned that some bank transactions might appear
to circumvent section 106. For example, the examiners found one instance
in which a nonbank affiliate had tied bridge loans to the purchase of
securities underwriting and syndicated some or all of the loans to its
commercial bank. The examiners noted that although this issue had not
been addressed in the guidance available at the time, this arrangement
created the appearance of an attempt to circumvent the application of
section 106. The bank thereupon discontinued the practice. As mentioned
previously, because section 106 applies only to banks, it is not a violation of
the section for most nonbank affiliates of commercial banks to tie together
any two products or services. The proposed interpretation of section 106
recently issued by the Federal Reserve addresses this issue.

Finally, the examiners found that one bank might be overstating the relief
gained from the foreign transactions safe harbor. The Federal Reserve
adopted a safe harbor from the antitying rules for transactions with
corporate customers that are incorporated or otherwise organized and that



26
   A bridge loan is an interim financing arrangement provided by a bank, investment bank, or
special purpose investment fund to allow a corporation to make an acquisition before
arranging permanent financing to carry the acquisition.




Page 23                                                                GAO-04-3 Bank Tying
                              have their principal place of business outside the United States.27 This safe
                              harbor also applies to individuals who are citizens of a foreign country and
                              are not resident in the United States. The new guidance developed by the
                              banking regulators does not address the examiners’ specific concerns.
                              Federal Reserve officials said that a general rule on these issues would not
                              be feasible and that any determinations would depend on the facts and
                              circumstances of the specific transactions.



The Federal Reserve’s         Based on the interpretive issues examiners found during the special
Proposed Interpretation and   targeted review and its analysis, and after significant consultation with
                              OCC, the Federal Reserve recently released for public comment a proposed
Guidance Released for
                              interpretation of section 106. The proposed interpretation noted that the
Public Comment                application of section 106 is complicated and heavily dependent on the
                              particular circumstances and facts of specific transactions. The proposed
                              guidance outlines, among other things, some of the information that would
                              be considered in determining whether a transaction or proposed
                              transaction would be lawful or unlawful under section 106. Federal
                              Reserve officials also have noted that another desired effect of additional
                              guidance could be providing bank customers a better understanding of
                              section 106 and what bank actions are lawful. The officials said that they
                              hoped that the new guidance would encourage customers to come forward
                              with any complaints. The deadline for public comments on the proposed
                              guidance was September 30, 2003. At the time of our review, the Federal
                              Reserve was reviewing comments that had been received.




                              27
                               See also, 83 Fed. Res. Bulletin 275 (April 1997). Federal Reserve Board Bank Holding
                              Company Supervision Manual, Section 3500.0.2.3, Safe Harbor for Foreign Transactions.




                              Page 24                                                             GAO-04-3 Bank Tying
Evidence That We           Although officials at one investment bank contended that large commercial
                           banks deliberately “underpriced”—or priced credit at below market rates—
Reviewed on the            corporate credit to attract underwriting business to their investment
Pricing of Corporate       affiliates, the evidence of “underpricing” is ambiguous and subject to
                           different interpretations. They claimed that these commercial banks
Credit Did Not             underprice credit in an effort to promote business at the banks’ investment
Demonstrate That           affiliates, which would increase the bank holding companies’ fee-based
Commercial Banks           income. Such behavior, they contended, could indicate violations of section
                           106, with credit terms depending on the customer buying the tied product.
Unlawfully Discount        The banking regulators also noted that pricing credit below market interest
Credit                     rates, if it did occur, could violate section 23B, with the bank’s income
                           being reduced for the benefit of its investment affiliate. Commercial
                           bankers counter that the syndication of these loans and loan
                           commitments—the sharing of them among several lenders—makes it
                           impossible to underprice credit, since the other members of the syndicate
                           would not participate at below market prices. Federal Reserve staff is
                           considering further research into the issue of loan pricing, which could
                           clarify the issue.

                           Investment bankers and commercial bankers also disagreed whether
                           differences between the prices for loans and loan commitments and those
                           for other credit products indicated that nonmarket forces were involved in
                           setting credit prices. Both investment bankers and commercial bankers
                           cited specific transactions to support their contentions; in some cases, they
                           pointed to the prices for the same loan products at different times.
                           Commercial bankers also noted that their business strategies called for
                           them to ensure the profitability of their relationship with customers; if
                           market-driven credit prices alone did not provide adequate profitability, the
                           strategies commonly called for marketing an array of other products to
                           make the entire relationship a profitable one. The banking regulators noted
                           that such strategies would be within the bounds of the law as long as the
                           bank customers had a “meaningful choice” that includes traditional bank
                           products.



Investment Affiliates of   In recent years, the market share of the fees earned from debt and equity
Commercial Banks Have      underwriting has declined at investment banks and grown at investment
                           affiliates of commercial banks. In 2002, the three largest investment banks
Gained Market Share in     had a combined market share of 31.9 percent, a decline from a 38.1 percent
Underwriting               market share that these investment banks held in 1995. In comparison, the
                           market share of the three largest investment affiliates of commercial banks



                           Page 25                                                    GAO-04-3 Bank Tying
                            was 30.4 percent in 2002, compared with their 17.8 percent market share
                            that these investment banks held in 1995. Some of this growth might be the
                            result of the ability of commercial banks and their investment affiliates to
                            offer a wide array of financial services. However, banking regulators noted
                            that industry consolidation and the acquisition of investment banking firms
                            by bank holding companies also has been a significant factor contributing
                            to this growth. For example, regulators noted that Citigroup Inc. is the
                            result of the 1998 merger of Citicorp and Travelers Group Inc., which
                            combined Citicorp’s investment business with that of Salomon Smith
                            Barney, Inc., a Travelers subsidiary that was already a prominent
                            investment bank. J.P. Morgan & Co. Incorporated and The Chase
                            Manhattan Corporation also combined in 2000 to form J.P. Morgan Chase &
                            Co.



Pricing Evidence from the   Some investment bankers contended that commercial banks offer loans
Secondary Market Is         and loan commitments to corporate borrowers at below-market rates if
                            borrowers agree to engage the services of their investment affiliates. Large
Inconclusive
                            loans and loan commitments to corporations—including the lines of credit
                            that borrowers use in conjunction with issuing commercial paper—are
                            frequently syndicated.28 A syndicated loan is financing provided by a group
                            of commercial banks and investment banks whereby each bank agrees to
                            advance a portion of the funding. Commercial bankers contended that
                            these prices of the loans and loan commitments reflected a competitive
                            market, where individual lenders have no control over prices.

                            Officials from one investment bank who contended that banking
                            organizations have underpriced credits to win investment banking business
                            drew comparisons between the original pricing terms of specific
                            syndicated loans and the pricing of the same loans in the secondary
                            market. Specifically, they pointed to several transactions, including one in
                            which they questioned the pricing but participated because the borrower
                            insisted that underwriters provide loan commitments. The investment bank
                            officials said that when they subsequently attempted to sell part of their


                            28
                              Commercial paper is an unsecured obligation issued by a corporation or bank to finance
                            its short-term credit needs, such as accounts receivable and inventory. Commercial paper is
                            usually issued by companies with high credit ratings. Commercial paper is available in a
                            wide range of denominations and can be either discounted or interest bearing. Maturities for
                            commercial paper typically range from 2 to 270 days. Commonly, companies issuing
                            commercial paper will also obtain a backup loan commitment that would provide funds if
                            the company is unable to payoff or roll over the commercial paper as it matures.




                            Page 26                                                                GAO-04-3 Bank Tying
share of the credits, the pricing was unattractive to the market and that
they could not get full value. In one case, they noted that the credit facility
was sold in the secondary market at about 93 cents on the dollar shortly
after origination. They said that, in their opinion, this immediate decline in
value was evidence that the credit facility had been underpriced at
origination.

Commercial bankers said that competition in the corporate loan market
determines loan pricing. One banker said that if a loan officer overpriced a
loan by even a basis point or two the customer would turn to another
bank.29 Bankers also noted that if loans were underpriced, the syndicators
would not be able to syndicate the loan to investors who are not engaged in
debt underwriting and insist on earning a competitive return. An official
from one commercial bank provided data on its syndicated loans, showing
that a number of the participants in the loans and loan commitments did
not participate in the associated securities underwriting for the borrower
and—in spite of having no investment banking business to win—found the
terms of the loans and loan commitments attractive. However, we do not
know the extent, if any, to which these other participants might have had
other revenue-generating business with the borrowers.

Officials from a commercial bank and loan market experts also said that
the secondary market for loans was illiquid, compared with that for most
securities. The bank officials said that therefore prices could swing in
response to a single large sale as a result of this illiquidity. Officials from
one commercial bank said that the price of the loan to which investment
bank officials referred, which had sold for about 93 cents on the dollar
shortly after origination, had risen to about 98 cents on the dollar in
secondary trades a few months later. These officials said that, in their
opinion, this return in pricing toward the loan’s origination value is proof
that the syndicated loan was never underpriced and that the movement in
price was the result of a large portion of the facility being sold soon after
the origination. Independent loan market experts also observed that
trading in loan commitments is illiquid, and thus subsequent price
fluctuations might not reflect fair value.




29
     A basis point is a measure of a bond’s yield, equal to 1/100th of 1 percent of yield.




Page 27                                                                      GAO-04-3 Bank Tying
Pricing Evidence from      Commercial bankers and investment bankers disagreed on whether a
Credit Default Swap        comparison of the prices of loans and other credit products demonstrated
                           underpricing. In particular, one key disagreement involved the use of credit
Markets Is Subject to      default swaps.30 Banks and other financial institutions can use credit
Multiple Interpretations   default swaps, among other instruments, to reduce or diversify credit risk
                           exposures. With a credit default swap, the lender keeps the loan or loan
                           commitment on its books and essentially purchases insurance against
                           borrower default.

                           Officials at one investment bank compared the prices of syndicated loans
                           with the prices of credit default swaps used to hedge the credit risk of the
                           loan. In their view, the differences in the two prices demonstrated that
                           commercial banks underpriced corporate credit. They provided us with
                           several examples of syndicated loans, wherein the difference between the
                           interest rate on the loan or loan commitment and the corresponding credit
                           default swap was so great that the investment bankers believed that the
                           bank would have earned more from insuring the credit than extending it.

                           On the other hand, Federal Reserve officials, commercial bankers, and loan
                           market experts disputed the extent to which the pricing of corporate credit
                           could be compared with their corresponding credit default swaps, because
                           of important differences between the two products and between the
                           institutions that dealt in them. Officials from the Federal Reserve noted
                           that the triggering mechanisms for the two products differed. Although the
                           trigger for the exercise of a credit default swap is a clearly defined
                           indication of the borrower’s credit impairment, the exercise of a
                           commercial paper back-up line is triggered by the issuer’s inability to
                           access the commercial paper market—an event that could occur without
                           there necessarily being any credit impairment of the issuer. For example, in
                           1998, Russia’s declaration of a debt moratorium and the near-failure of a
                           large hedge fund created financial market turmoil; since this severely
                           disrupted corporations’ issuance of bonds and commercial paper, they
                           drew on their loan commitments from banks. In addition, loan market


                           30
                              Credit default swaps are financial contracts that allow the transfer of credit risk from one
                           market participant to another, potentially facilitating greater efficiency in the pricing and
                           distribution of credit risk among financial market participants. In a “plain vanilla” credit
                           default swap, the protection buyer agrees to make periodic payments (the swap “spread” or
                           premium) over a predetermined number of years (the maturity of the credit default swap) to
                           the protection seller in exchange for a payment in the event of default by a third party.
                           Typically, credit default swaps premiums are paid quarterly, and the most common
                           maturities are 3, 5, and 10 years.




                           Page 28                                                                  GAO-04-3 Bank Tying
                               experts and officials from a commercial bank also said that the loan market
                               and the credit default swap market involve different participants with
                               different motivations. Loan market experts noted that lead originators of
                               loans and loan commitments have an advantage gained from knowledge of
                               the borrower through direct business relationships. On the other hand,
                               those who provide credit protection by selling credit swap might be entities
                               with no direct knowledge of the customer’s creditworthiness, but use these
                               instruments for diversifying risks.



Evidence from the Pricing      To present their differing positions on whether or not credit is underpriced,
of Undrawn Fees Did Not        investment bankers, loan market experts, and commercial bankers
                               discussed the pricing of selected syndicated loan commitments. In
Resolve Whether
                               syndicated loan commitments, participants receive commitment fees on
Commercial Banks               the undrawn amount and a specified interest rate if the loan is drawn. In
Unlawfully Price Credit Risk   addition, participants in syndicated loan commitments are protected from
                               certain risks by various conditions. Also, the lead participant might receive
                               an up-front fee from the borrower. Each of these factors can influence the
                               price of the loan commitment.

                               Officials at one investment bank noted that the pricing for undrawn loan
                               commitments provided as back-up lines for commercial paper issuers have
                               been low for several years and had been relatively stable, even when other
                               credit market prices fluctuated. Available data showed that this was the
                               case for the fees for undrawn commitments provided for investment-grade
                               borrowers, with undrawn fees averaging under 0.10 percent per year of the
                               undrawn amount. The investment bankers further noted that the loan
                               commitment would be drawn in the event of adverse conditions for the
                               borrower in the commercial paper market. Thus, commercial paper back-
                               up lines exposed the provider to the risk that they might have to book loans
                               to borrowers when they were no longer creditworthy. In the opinion of
                               these investment bankers, the low undrawn loan fees do not reflect this
                               risk.

                               In contrast, officials from commercial banks and loan market experts said
                               that the level of undrawn fees for loan commitments did not represent all
                               the ways that commercial banks might adjust credit terms to address rising
                               credit risk. These officials said that in response to perceived weakening in
                               credit quality, lenders had shortened the maturity of credit lines. Lenders
                               also tightened contract covenants to protect themselves against a
                               borrowers’ potential future weakening. In addition, commercial bank
                               officials told us that other factors were involved in the pricing of loan



                               Page 29                                                    GAO-04-3 Bank Tying
                             commitments. For example, they said that a comprehensive analysis
                             should include the upfront fees to measure the total return on undrawn
                             loan commitments. However, loan market experts said that published loan
                             pricing data do not include the up-front fees that many banks collect when
                             they extend credit. Thus, publicly available information was insufficient to
                             indicate the total return commercial banks received on such lending.



Investment Banks and         Officials at one investment bank claimed that because the fees that
Commercial Banks Have        commercial banks receive for corporate credits barely exceed their cost of
                             funds, commercial banks are not covering all of their costs and are in
Different Views on the
                             essence subsidizing corporate credits. Conversely, several bankers said
Profitability of Corporate   that the rates they can charge on corporate credits do exceed their cost of
Lending                      funds but are not always high enough to allow them to meet their
                             institution’s profitability targets. Officials at one commercial bank noted
                             that their internal controls included separation of powers, where any
                             extensions of credit over $10 million would have to be approved by a credit
                             committee rather than those responsible for managing the bank’s customer
                             relationships. However, these same officials said that they often base
                             lending decisions on the profitability of customer relationships, not
                             individual products. Thus, a loan that might not reach profitability targets
                             on a stand-alone basis could still be attractive as part of an overall
                             customer relationship.



Federal Reserve Staff Is     During our review, members of the Federal Reserve’s staff said that they
Considering a Study about    were considering conducting research into pricing issues in the corporate
                             loan market. Such research could shed some additional light on the charges
Loan Pricing                 of the investment bankers and the responses of the commercial bankers.31
                             It also could provide useful supervisory information. If the study finds
                             indications that pricing of credit to customers who also use underwriting
                             services is lower than other comparable credit, this could lend support to
                             the investment banker’s allegations of violations of section 23B. However, if
                             the charges are not valid and credit pricing does reflect market conditions,

                             31
                                Preliminary results from an academic study of loan pricing and securities underwriting
                             suggest that the rates charged on loans to corporate borrowers who subsequently purchase
                             underwriting services from an investment affiliate of the lender were not lower than rates
                             charged on loans not followed by the purchase of underwriting services. See Charles W.
                             Calomiris and Thanavult Pornrojnangkool, “Tying, Relationship Banking, and the Repeal of
                             Glass Stegall,” Unpublished paper presented at the American Enterprise Institute, Sept. 24,
                             2003.




                             Page 30                                                               GAO-04-3 Bank Tying
                          this information would serve as useful confirmation of the findings of the
                          Federal Reserve-OCC targeted review, which found that the policies and
                          procedures of the largest commercial banks served as effective deterrents
                          against unlawful tying.



Differences between       Based on our analysis, the different accounting methods, capital
                          requirements, and levels of access to the federal safety net did not appear
Commercial Banks and      to give commercial banks a consistent competitive advantage over
Investment Banks Did      investment banks. Officials at some investment banks asserted that these
                          differences gave commercial banks an unfair advantage that they could use
Not Necessarily Affect    in lending to customers who also purchase debt-underwriting services from
Competition               their investment affiliates. Under current accounting rules, commercial
                          banks and investment banks are required to use different accounting
                          methods to record the value of loan commitments and loans. Although
                          these different methods could cause temporary differences in the financial
                          statements for commercial banks and investment banks. While these
                          different methods could cause temporary differences in financial
                          statements, these differences would be reconciled at the end of the credit
                          contract periods. Further, if the loan commitment were exercised and both
                          firms either held the loan until maturity or made the loan available for sale,
                          the accounting would be similar and would not provide an advantage to
                          either firm. Additionally, while commercial and investment banks were
                          subject to different regulatory capital requirements, practices of both
                          commercial and investment banks led to avoidance of regulatory charges
                          on loan commitments with a maturity of 1 year or less. Moreover, while the
                          banks had different levels of access to the federal safety net, some industry
                          observers argued that greater access could be offset by corresponding
                          greater regulatory costs.



Commercial Banks and      According to FASB, which sets the private sector accounting and reporting
Investment Banks Follow   standards, commercial banks and investment banks follow different
                          accounting models for similar transactions involving loans and loan
Different Accounting
                          commitments. Most commercial banks follow a mixed model, where some
Models for Loan           financial assets and liabilities are measured at historical cost, some at the
Commitments               lower of cost or market value and some at fair value. In contrast, some
                          investment banks follow a fair-value accounting model, in which they
                          report changes in the fair value of inventory, which may include loans or
                          loan commitments, in the periods in which the changes occur.




                          Page 31                                                     GAO-04-3 Bank Tying
Where FASB guidance is nonexistent, as is currently the case for fair-value
accounting for loan commitments, firms are required to follow guidance
from the AICPA, which provides industry specific accounting and auditing
guidance that is cleared by FASB prior to publication. FASB officials said
that it is currently appropriate for commercial banks and investment banks
to follow different accounting models because of their different business
models.

When commercial banks make loan commitments, they must follow FASB’s
Statement of Financial Accounting Standards (FAS) No. 91, Accounting for
Nonrefundable Fees and Costs Associated with Originating or Acquiring
Loans and Initial Direct Costs of Leases, which directs them to book the
historic carrying value of the fees received for loan commitments as
deferred revenue.32 In the historic carrying value model, commercial banks
are not allowed to reflect changes in the fair value of loan commitments in
their earnings. However, commercial banks are required to disclose the fair
value of all loan commitments in the footnotes to their financial
statements, along with the method used to determine fair value.33

Some investment banks follow the AICPA Audit and Accounting Guide,
Brokers and Dealers in Securities, which directs them to record the fair
value of loan commitments.34 The AICPA guidance is directed at broker-
dealers within a commercial bank or investment bank holding company
structure. However, some investment banks whose broker-dealer
subsidiaries comprised a majority of the firms’ financial activity would also
be required to follow the fair-value accounting model outlined in the AICPA
guidance for instruments held in all subsidiaries.35 When using the fair-
value model, investment banks must recognize in income gains or losses
resulting from changes in the fair value of a financial instrument, such as a


32
 The historic carrying value of a loan commitment is the value of the loan commitment
service fees at the time a firm extends the commitment. The fees received are recognized
either over the life of the loan commitment when the likelihood of the borrower exercising
the commitment is remote or over the life of the loan if the commitment is exercised.
33
     This is required by FAS No. 107, Disclosures about Fair Value of Financial Instruments.
34
   The fair value of a loan commitment is generally based on quoted market prices of similar
transactions or modeling with market data.
35
   It is important to note that, in practice, investment banks often do not hold loan
commitments in their broker-dealer subsidiaries because of the high capital requirements of
broker-dealers. (We discuss the regulatory capital requirements of broker-dealers in greater
detail in the next section.)




Page 32                                                                 GAO-04-3 Bank Tying
                           loan commitment. Investment banks said that they determine the current
                           fair value of loan commitments based on the quoted market price for an
                           identical or similar transaction or by modeling with market data if market
                           prices are not available.

                           According to FASB, although measurement of financial instruments at fair
                           value has conceptual advantages, not all issues have been resolved, and
                           FASB has not yet decided when, if ever, it will require essentially all
                           financial instruments held in its inventory to be reported at fair value. A
                           loan market expert said that, although the discipline of using market-based
                           measures works well for some companies, fair-value accounting might not
                           be the appropriate model for the entire wholesale loan industry. FASB said
                           that one reason is that in the absence of a liquid market for loan
                           commitments, there is potential for management manipulation of fair value
                           because of the management discretion involved in choosing the data used
                           to estimate fair value.



Some Investment Banks      Officials from some investment banks contended that adherence to
Contended That Different   different accounting models gave commercial banks a competitive
                           advantage relative to investment banks in lending to customers who also
Accounting Methods Give
                           purchased investment banking services. They alleged that commercial
Commercial Banks a         banks extended underpriced 364-day loan commitments to attract
Competitive Advantage      customers’ other, more profitable business—such as underwriting—but
                           they were not required to report on their financial statements the
                           difference in value, if any, between the original price of the loan
                           commitment and the current market price.36 The investment bank officials
                           contended that the current accounting standards facilitate this alleged
                           underpricing of credit because commercial banks record loan
                           commitments at their historic value rather than their current value, which
                           might be higher or lower, and do not have to report the losses incurred in
                           extending an allegedly underpriced loan commitment.

                           Officials from some investment banks also claimed that the historic
                           carrying value model allowed commercial banks to hide the risk of these
                           allegedly underpriced loan commitments from stockholders and market
                           analysts, because the model did not require them to report changes in the
                           value of loan commitments. Officials said that differences in accounting for

                           36
                              The historic carrying value model does not permit commercial banks to record these
                           changes in value.




                           Page 33                                                              GAO-04-3 Bank Tying
                             identical transactions might put investment banks at a disadvantage,
                             compared with commercial banks when analysts reviewed their quarterly
                             filings. As discussed in an earlier section, it is not clear that commercial
                             banks underprice loan commitments.



Commercial Banks Do Not      Although commercial and investment banks might have different values on
Enjoy a Consistent           their financial statements for similar loan commitments, both are subject to
                             the same fair-value footnote disclosure requirements in which they report
Competitive Advantage over
                             the fair value of all loan commitments in their financial statement
Investment Banks in          footnotes, along with the method used to determine fair value. As a result,
Accounting for Loan          financial analysts and investors are presented with the same information
Commitments                  about the commercial and investment banks’ loan commitments in the
                             financial statement footnotes. According to FAS 107: Disclosures about
                             Fair Value of Financial Instruments, in the absence of a quoted market
                             price, firms estimate fair value based on (1) the market prices of similar
                             traded financial instruments with similar credit ratings, interest rates, and
                             maturity dates; (2) current prices (interest rates) offered for similar
                             financial instruments in the entity’s own lending activities; or (3) valuations
                             obtained from loan pricing services offered by various specialist firms or
                             from other sources. FASB said that they have found no conclusive evidence
                             that an active market for loan commitments exists; thus, the fair value
                             recorded might frequently be estimated through modeling with market
                             data. When a quoted market price for an identical transaction is not
                             available, management judgment and the assumptions used in the model
                             valuations could significantly affect the estimated fair value of a particular
                             financial instrument.

                             SEC and the banking regulators said the footnote disclosures included with
                             financial statements, which are the same for both commercial banks and
                             investment banks, were an integral part of communicating risk. They
                             considered the statement of position and statement of operations alone to
                             be incomplete instruments through which to convey the risk of loan
                             commitments. They emphasized that to fully ascertain a firm’s financial
                             standing, financial footnotes must be read along with the financial
                             statements.

                             Although different accounting models would likely introduce differences in
                             the amount of revenue or loss recognized in any period, all differences in
                             accounting for loan commitments that were not exercised would be
                             resolved by the end of the commitment period. Any interim accounting
                             differences between a commercial bank and investment bank would be



                             Page 34                                                      GAO-04-3 Bank Tying
relatively short-lived because most of these loan commitment periods are
less than 1 year. Further, if a loan commitment were underpriced, an
investment bank using the fair-value accounting model would recognize the
difference between the fair value and the contractual price as a loss, while
a commercial bank using the historical cost model would not be permitted
to do so. This difference in the recognition of gains or losses would be
evident in commercial and investment banks’ quarterly filings over the
length of the commitment period. However, there is no clear advantage to
one method over the other in accounting for loan commitments when the
commitments are priced consistently between the two firms at origination.

According to investment bankers we spoke with and staff from the AICPA,
loan commitments generally decline in value after they are made. Under
fair-value accounting, these declines in fair value are actually recognized by
the investment bank as revenue because the reduction is recognized in a
liability account known as deferred revenue. Therefore, if an investment
bank participated with commercial banks in a loan commitment that was
deemed underpriced, any initial loss recognized by the investment bank
would be offset by each subsequent decline in the loan commitment’s fair
value. Further, as discussed in an earlier section, it is not clear that
commercial banks underprice loan commitments. Whether a commercial
bank using the historic carrying value model or an investment bank using
the fair-value model would recognize more revenue or loss on a given loan
commitment earlier or later would depend on changes in the borrower’s
credit pricing, which reflects overall market trends and customer-specific
events, as well as on the accounting model that the firm follows.

In addition, when similar loan commitments held by a commercial bank
and an investment bank are exercised and become loans, both firms would
be subject to the same accounting standards if they had the intent and
ability to hold the loan for the foreseeable future or to maturity.37 In this
situation, both commercial banks and investment banks would be required
to establish an allowance for probable or possible losses, based on the




37
   Although investment banks generally classify financial instruments as inventory and
account for them at fair value, AICPA Task Force members and some investment bankers
noted that, in some instances, the firms might decide to hold a loan for the foreseeable
future or until maturity. In this case, the loan would not be classified as held-for-sale and
would not be accounted for at fair value.




Page 35                                                                  GAO-04-3 Bank Tying
                            estimated degree of impairment of the loan commitment or historic
                            experience with similar borrowers.38

                            If both an investment bank and a commercial bank decided to sell a loan
                            that it previously had the intent and ability to hold for the foreseeable
                            future or until maturity, the firms would follow different guidance that
                            would produce similar results. A commercial bank would follow the
                            AICPA’s Statement of Position 01-6, Accounting by Certain Entities
                            (Including Entities With Trade Receivables) That Lend to or Finance the
                            Activities of Others that was issued in December, 2001. According to this
                            guidance, once bank management decides to sell a loan that had not been
                            previously classified as held-for-sale, the loan’s value should be adjusted to
                            the lower of historical cost or fair value, and any amount by which
                            historical cost exceeds fair value should be accounted for as a valuation
                            allowance. Further, as long as the loan’s fair value remained less than
                            historical cost, any subsequent changes in the loan’s fair value would be
                            recognized in income. The investment bank would follow the guidance in
                            the AICPA’s Audit and Accounting Guide, Brokers and Dealers in
                            Securities, and account for inventory, the loan in this instance, at fair value
                            and recognize changes in the fair value in earnings.



Capital Requirements Do     Regulatory capital is the minimum long-term funding level that financial
Not Give Commercial Banks   institutions are required to maintain to cushion themselves against
                            unexpected losses, and differing requirements for commercial banks and
a Competitive Advantage
                            broker-dealers reflect distinct regulatory purposes.39 The primary purposes
                            of commercial bank regulatory capital requirements are to maintain the
                            safety and soundness of the banking and payment systems and to protect
                            the deposit insurance funds. Under the bank risk-based capital guidelines,
                            off-balance sheet transactions, such as loan commitments, are converted



                            38
                              According to FAS 114: Accounting by Creditors for Impairment of a Loan, a loan is
                            considered impaired when, based on current information and events, it is probable that a
                            creditor will be unable to collect all amounts due according to the contractual terms of the
                            loan agreement. To comply with FAS 114, creditors must create a valuation allowance that
                            reduces the value of the loan with a corresponding charge to a bad-debt expense. When a
                            loan is not impaired, creditors must follow FAS 5: Accounting for Contingencies and
                            establish an allowance for loss when there is at least a reasonable possibility that a loss or
                            an additional loss might be incurred.
                            39
                               U.S. General Accounting Office, Risk Based Capital: Regulatory and Industry
                            Approaches to Capital and Risk, GAO/GGD-98-153 (Washington, D.C.: July 1998).




                            Page 36                                                                  GAO-04-3 Bank Tying
into one of four categories of asset equivalents.40 Unfunded loan
commitments of one year or less are assigned to the zero percent
conversion category, which means that banks are not required to hold
regulatory capital for these commitments. In contrast, the primary
purposes of broker-dealers’ capital requirements are to protect customers
and other market participants from losses caused by broker-dealer failures
and to protect the integrity of the financial markets. The SEC net capital
rule requires broker-dealer affiliates of investment banks to hold 100-
percent capital against loan commitments of any length.41 However,
nonbroker-dealer affiliates of investment banks are not subject to any
regulatory capital requirements, and are therefore not required to hold
regulatory capital against loan commitments of any length.

It is costly for banks or other institutions to hold capital; thus, to the extent
that the level of regulatory capital requirements determines the amount of
capital actually held, lower capital requirements can translate into lower
costs. Officials from an investment bank contended that bank capital
requirements gave commercial banks with investment affiliates a cost
advantage they could use when lending to customers who also purchased
underwriting business. They said that because banks’ regulatory capital
requirements for unfunded credits of 1 year or less were zero, commercial
banks had the opportunity to adjust the length of credit commitments to
avoid capital charges. Furthermore, officials said that the ability to avoid
capital charges allowed commercial banks to underprice these loan
commitments, because they could extend the commitments without the
cost of assigning additional regulatory capital. They pointed to the high
percentage of credit commercial banks structured in 364-day facilities as
evidence that banks structure underpriced credit in short-term
arrangements to avoid capital charges.

We found no evidence that bank regulatory capital requirements provided
commercial banks with a competitive advantage. Although investment
banks could face a 100-percent regulatory capital charge if they carried
loan commitments in their broker-dealer affiliates, investment bank
officials and officials from the SEC said that, in practice, investment banks
carried loan commitments outside of their broker-dealer affiliates, and thus

40
 Effective 1990, U.S. banking regulators added regulatory capital requirements for loan
commitments with maturities greater than 1 year. Previously, there had been no regulatory
capital requirements for unfunded loan commitments of any length.
41
     SEC Rule 15c3-1(c)(2)(viii).




Page 37                                                              GAO-04-3 Bank Tying
                          avoided all regulatory capital charges. Furthermore, banking regulators did
                          not think that the current regulatory capital requirements adversely
                          affected the overall amount of capital banks held, because commercial
                          banks generally carried internal risk-based capital on instruments—
                          including loan commitments—that were in excess of the amount of
                          regulatory capital required. In addition, the banking regulators said that
                          bank regulatory capital requirements had not affected banks’ use of loan
                          commitments of 1 year or less. Although loan market data indicated that
                          the percentage of investment-grade loans structured on 364-day terms has
                          increased, commercial bank officials and banking regulators said that this
                          shift was, in part, the banks’ response to the increased amount of risk in
                          lending.



Industry Observers and    Commercial banks have access to a range of services sometimes described
Some Banking Regulators   as the federal safety net, which includes access to the Federal Reserve
                          discount window and deposit insurance.42 The Federal Reserve discount
Doubt That the Federal    window allows banks and other organizations to borrow funds from the
Safety Net Provides       Federal Reserve.43 Commercial banks’ ability to hold deposits backed by
Commercial Banks with a   federal deposit insurance provides them with a low-cost source of funds
Competitive Advantage     available for lending.

                          Industry observers and banking regulators agreed that commercial banks
                          receive a subsidy from the federal safety net; however, they differed on the
                          extent to which the subsidy was offset by regulatory costs. Although
                          officials at the Federal Reserve and at an investment bank contended that
                          access to the federal safety net gave commercial banks a net subsidy,
                          officials from OCC and an industry observer said that the costs associated
                          with access to the safety net might offset these advantages. We could not
                          measure the extent to which regulatory costs offset the subsidy provided
                          by the access to the federal safety net because reliable measures of the
                          regulatory costs borne by banks were not available.

                          42
                             The federal safety net also includes access to the Federal Reserve payments system.
                          Because the investment bankers with whom we spoke did not mention the payments system
                          as a competitive advantage, we omitted this aspect from our discussion of the federal safety
                          net.
                          43
                           In unusual and exigent circumstances, and after consulting with the Board of Governors of
                          the Federal Reserve System, a Federal Reserve Bank can extend credit to an individual,
                          partnership, or corporation that is not a depository institution if, in the judgment of the
                          Federal Reserve Bank, credit is not available from other sources and failure to obtain such
                          credit would adversely affect the economy.




                          Page 38                                                                GAO-04-3 Bank Tying
Conclusions	   Although the Gramm-Leach-Bliley Act of 1999, among other things,
               expanded the ability of financial services providers, including commercial
               banks and their affiliates, to offer their customers a wide range of products
               and services, it did not repeal the tying prohibitions of section 106, which
               remains a complex provision to enforce. Regulatory guidance has noted
               that some tying arrangements involving corporate credit are clearly lawful,
               particularly those involving ties between credit and traditional bank
               products. The targeted review conducted by the Federal Reserve and OCC,
               however, identified other arrangements that raise interpretive issues that
               were not addressed in prevailing guidance. The Federal Reserve recently
               issued for public comment a proposed interpretation of section 106 that is
               intended to provide banks and their customers a guide to the section. As
               the proposed interpretation notes, however, the complexity of section 106
               requires a careful review of the facts and circumstances of each specific
               transaction. The challenge for the Federal Reserve and OCC remains that
               of enforcing a law where determining whether a violation exists or not
               depends on considering the precise circumstances of specific transactions;
               however, information on such circumstances is inherently limited.
               Customers have a key role in providing information that is needed to
               enforce section 106. However, the Federal Reserve and OCC have little
               information on customers’ understanding of lawful and unlawful tying
               under section 106 or on customers’ knowledge of the circumstances of
               specific transactions.

               The available evidence did not clearly support contentions that banks
               violated section 106 and unlawfully tied credit availability or underpriced
               credit to gain investment banking revenues. Corporate borrowers generally
               have not filed complaints with the banking regulators and attribute the lack
               of complaints, in part, to a lack of documentary evidence and uncertainty
               about which tying arrangements section 106 prohibits. The Federal Reserve
               and OCC report that they found only limited evidence of even potentially
               unlawful tying practices involving corporate credit during a targeted review
               that began in 2002, and they found that the banks surveyed generally had
               adequate policies and procedures in place to deter violations of section
               106. However, while the teams conducting this review analyzed some
               specific transactions, they did not test a broad range of transactions, or
               outreach widely to bank customers. Information from customers could be
               an important step in assessing both implementation of and compliance
               with a bank’s policies and procedures. While regulators could take further
               steps to encourage customers to provide information, in addition to the




               Page 39                                                    GAO-04-3 Bank Tying
                      recent Federal Reserve proposal, bank customers themselves are crucial to
                      enforcement of section 106.



Recommendations for   Distinguishing lawful and unlawful tying depends on the specific facts and
                      circumstances of individual transactions. Because the facts, if any, that
Executive Action      would suggest a tying violation generally would not be found in the loan
                      documentation that banks maintain and because bank customers have
                      been unwilling to file formal complaints, effective enforcement of section
                      106 requires an assessment of other indirect forms of evidence. We
                      therefore recommend that the Federal Reserve and the OCC consider
                      taking additional steps to ensure effective enforcement of section 106 and
                      section 23B, by enhancing the information that they receive from corporate
                      borrowers. For example, the agencies could develop a communication
                      strategy targeted at a broad audience of corporate bank customers to help
                      ensure that they understand which activities are permitted under section
                      106 as well as those that are prohibited. This strategy could include
                      publication of specific contact points within the agencies to answer
                      questions from banks and bank customers about the guidance in general
                      and its application to specific transactions, as well as to accept complaints
                      from bank customers who believe that they have been subjected to
                      unlawful tying. Because low priced credit could indicate a potential
                      violation of section 23B, we also recommend that the Federal Reserve
                      assess available evidence regarding loan pricing behavior, and if
                      appropriate, conduct additional research to better enable examiners to
                      determine whether transactions are conducted on market terms and that
                      the Federal Reserve publish the results of this assessment.



Agency Comments 	     We requested comments on a draft of this report from the Federal Reserve
                      and OCC. We received written comments from the Federal Reserve and
                      OCC that are summarized below and reprinted in appendixes II and III
                      respectively. The Comptroller of the Currency and the General Counsel of
                      the Board of Governors of the Federal Reserve System replied that they
                      generally agreed with the findings of the report and concurred in our
                      recommendations. Federal Reserve and OCC staff also provided technical
                      suggestions and corrections that we have incorporated where appropriate.


                      As agreed with your office, unless you publicly announce its contents
                      earlier, we plan no further distribution of this report until 30 days from its



                      Page 40                                                      GAO-04-3 Bank Tying
issuance date. At that time, we will send copies the Chairman and Ranking 

Minority Member, Senate Committee on Banking, Housing, and Urban 

Affairs; the Chairman, House Committee on Energy and Commerce; the 

Chairman of the Board of Governors of the Federal Reserve System; and 

the Comptroller of the Currency. We will make copies available to others 

upon request. In addition, the report will be available at no charge on the 

GAO Web site at http://www.gao.gov. 


If you or your staff have any questions about this report, please contact 

James McDermott or me at (202) 512-8678. Key contacts and major 

contributors to this report are listed in appendix IV. 


Sincerely yours,





Richard Hillman, Director

Financial Markets and Community Investment





Page 41                                                    GAO-04-3 Bank Tying
Appendix I

Differences in Accounting between
Commercial and Investment Banks for Loan
Commitments
              Because commercial and investment banks follow different accounting
              models, there are differences in the financial statement presentation of
              some similar transactions. This appendix summarizes the differences,
              under generally accepted accounting principles in how commercial banks
              and investment banks account for loan commitments—specifically
              commercial paper back-up credit facilities—using hypothetical scenarios
              to illustrate how these differences could affect the financial statements of a
              commercial and investment bank. 1 We use three hypothetical scenarios to
              illustrate the accounting differences that would occur between the
              commercial and investment banks for similar transactions if (1) a loan
              commitment were made, (2) the loan commitment was exercised by the
              borrower and the loan was actually made, and (3) the loan was
              subsequently sold. This appendix does not assess the differences in
              accounting that would occur if a loan was made by both a commercial bank
              and an investment bank when one entity decided to hold the loan to
              maturity and the other opted to hold the loan as available for sale, because
              the basis for these actions and the resulting accounting treatment are not
              similar.

              The examples in this appendix demonstrate that, as of a given financial
              statement reporting date, differences would likely exist between
              commercial and investment banks in the reported value of a loan
              commitment and a loan resulting from an exercised commitment, as well
              as the recognition of the related deferred revenue. In addition, the volatility
              of the fair value of loan commitments and the related loan, if the
              commitment were exercised, would be reflected more transparently in an
              investment bank’s financial statements, because an investment bank must
              recognize these changes in value in earnings as they occur in net income.2
              In contrast, commercial banks are not allowed to recognize changes in the
              fair value of the loan commitment, its related deferred revenue, or the
              related loan (if drawn). The differences in accounting between commercial
              banks and investment banks are temporary; and, as the examples in the
              following sections show, whether a commercial bank or an investment


              1
               Commercial paper is generally a short-term, unsecured, money-market obligation issued by
              prime rated commercial firms and financial companies. A commercial paper back-up facility
              is generally a short-term bank line of credit that serves as an alternate source of liquidity for
              an issuer of commercial paper lasting less than 1 year.
              2
               FASB has defined fair value in FAS 107, Disclosures about Fair Value of Financial
              Instruments, as the amount at which a financial instrument could be exchanged in a current
              transaction between willing parties, other than a forced liquidation sale.




              Page 42                                                                    GAO-04-3 Bank Tying
              Appendix I

              Differences in Accounting between

              Commercial and Investment Banks for Loan 

              Commitments





              bank recognizes more fee revenue first would depend on various market
              conditions, including interest rates and spreads. Similarly, any differences
              between the fair value of a loan or loan commitment on an investment
              bank’s book and the net book value of a similar loan or loan commitment
              on a commercial bank’s books would be eliminated by the end of the loan
              term or commitment period.3 Given that loan commitment terms are
              usually for less than 1 year, any accounting differences between the
              commercial and investment banks would be for a relatively short period of
              time. Further, both commercial and investment banks are required to make
              similar footnote disclosures about the fair value of their financial
              instruments.4 Thus, neither accounting model provides a clear advantage
              over the life of the loan commitment or the loan if the commitment were
              exercised.



Background	   Since 1973, the Financial Accounting Standards Board (FASB) has been
              establishing private-sector financial accounting and reporting standards. In
              addition, the American Institute of Certified Public Accountants (AICPA)
              Accounting Standards Executive Committee also provides industry-
              specific authoritative guidance that is cleared with FASB prior to
              publication. Where FASB guidance is nonexistent, as is currently the case
              in fair-value accounting for loan commitments, firms are required to follow
              AICPA guidance.

              Most commercial banks generally follow a mixed-attribute accounting
              model, where some financial assets and liabilities are measured at
              historical cost, some at the lower of cost or market value and some at fair
              value. In accounting for loan commitments, banks follow the guidance in
              Statement of Financial Accounting Standards (FAS) Number 91




              3
               The net book value of a loan is generally its unpaid principal balance less any allowance for
              credit losses.
              4
               FASB has defined a financial instrument as cash, evidence of an ownership interest in an
              entity, or a contract that both imposes on one entity a contractual obligation to (1) deliver
              cash or another financial instrument to a second entity or (2) to exchange other financial
              instruments on potentially unfavorable terms with the second entity and conveys to that
              second entity a contractual right to (1) receive cash or another financial instrument from the
              first entity or (2) to exchange other financial instruments on potentially favorable terms
              with the first entity.




              Page 43                                                                 GAO-04-3 Bank Tying
Appendix I

Differences in Accounting between

Commercial and Investment Banks for Loan 

Commitments





Accounting for Nonrefundable Fees and Costs Associated with
Originating or Acquiring Loans and Initial Direct Costs of Leases.5
Broker-dealer affiliates and investment banks whose primary business is to
act as a broker-dealer follow the AICPA’s Audit and Accounting Guide,
Brokers and Dealers in Securities, where the inventory (that may include
loan commitments) are recorded at the current fair value and the change in
value from the prior period is recognized in net income.6 Further, FASB
currently has a project on revenue recognition that includes the accounting
for loan commitment fees by investment banks and others. The purpose of
that project includes addressing the inconsistent recognition of
commitment fee income and may eliminate some of the accounting
differences that exist between commercial banks and investment banks
described in this appendix.

FASB has stated that it is committed to work diligently toward resolving, in
a timely manner, the conceptual and practical issues related to determining
the fair values of financial instruments and portfolios of financial
instruments. Further, FASB has stated that while measurement at fair value
has conceptual advantages, all implementation issues have not yet been
resolved; and the Board has not yet decided when, if ever, it will be feasible
to require essentially all financial instruments to be reported at fair value in
the basic financial statements. Although FASB has not yet issued
comprehensive guidance on fair-value accounting, recent literature has
stated that the fair-value accounting model provides more relevant
information about financial assets and liabilities and can keep up with


5
 FAS 91 Accounting for Nonrefundable Fees and Costs Associated with Originating or
Acquiring Loans and Initial Direct Costs of Leases applies to loan commitments held by
lending institutions. If a commercial bank held a loan commitment in a broker-dealer
affiliate registered with the Securities and Exchange Commission, the affiliate would follow
the AICPA guidance for broker-dealers.
6
 For simplicity, in this appendix the term investment bank will be used to mean an
investment bank in which the broker-dealer comprises a majority of the financial activity. In
practice, investment banks do not often hold loan commitments in their broker-dealer
affiliates because of the high capital requirements of broker-dealers; rather, the investment
bank would generally hold these financial instruments in a nonbroker-dealer affiliate.
However, according to AICPA staff, at the consolidated level, the entity would retain the
specialized accounting model used for the broker-dealer subsidiary. The commercial bank
would continue to use FAS 91 to account for its loan commitments. A nonbroker-dealer that
is a subsidiary of a broker-dealer holding company (not a bank holding company) may also
follow the accounting used by its broker-dealer subsidiary, if the broker-dealer comprises
the majority of the financial activity of the consolidated entity; that is, the fair-value model
would also be used for the consolidated broker-dealer holding company financial
statements.




Page 44                                                                   GAO-04-3 Bank Tying
                              Appendix I

                              Differences in Accounting between

                              Commercial and Investment Banks for Loan 

                              Commitments





                              today’s complex financial instruments better than the historical cost
                              accounting model. The effect of the fair-value accounting model is to
                              recognize in net income during the current accounting period amounts
                              that, under the historical cost model, would have been referred to as
                              unrealized gains or losses because the bank did not sell or otherwise
                              dispose of the financial instrument. Further, proponents of the fair-value
                              accounting model contend that unrealized gains and losses on financial
                              instruments are actually lost opportunities as of a specific date to realize a
                              gain or loss by selling or settling a financial instrument at a current price.
                              However, a disadvantage of fair-value accounting exists when there is not
                              an active market for the financial instrument being valued. In this case, the
                              fair value is more subjective and is often determined by various modeling
                              techniques or based on the discounted value of expected future cash flows.



Hypothetical Scenario         On the first day of an accounting period, Commercial Bank A and
                              Investment Bank B each made a $100 million loan commitment to a highly
for Unexercised Loan          rated company to back up a commercial paper issuance. This loan
Commitments                   commitment was irrevocable and would expire at the end of three quarterly
                              accounting periods. Because the loan commitment was issued to a highly
                              rated company, both banks determined that the chance of the company
                              drawing on the facility was remote. Both banks received $10,000 in fees for
                              these loan commitments. Commercial Bank A followed the guidance in
                              FAS No. 91 and recorded this transaction on a historical cost basis while
                              Investment Bank B, subject to specialized accounting principles that
                              require fair-value accounting, reported changes in fair value included the
                              effect of these changes in earnings.



Revenue Recognition for the   Upon receipt of the loan commitment fee, Commercial Bank A would
Commercial Bank	              record the $10,000 as a liability, called deferred revenue, because the bank
                              would be obligated to perform services in the future in order to “earn” this
                              revenue. In practice, because of the relatively small or immaterial amounts
                              of deferred revenue compared with other liabilities on a bank’s statement
                              of position (balance sheet), this amount would not be reported separately
                              and would likely be included in a line item called “other liabilities.”7
                              Commercial Bank A would follow the accounting requirements of FAS No.


                              7
                               The concept of materiality is discussed at length in FASB’s Concept Statement 2,
                              Qualitative Characteristics of Accounting Information, paragraphs 123 – 132.




                              Page 45                                                               GAO-04-3 Bank Tying
                              Appendix I

                              Differences in Accounting between

                              Commercial and Investment Banks for Loan 

                              Commitments





                              91 and recognize the revenue as service-fee income in equal portions over
                              the commitment period, regardless of market conditions—a practice often
                              referred to as revenue recognition on a straight-line basis. Thus, at the end
                              of the first accounting period, Commercial Bank A would reduce the
                              $10,000 deferred revenue on its statement of position (balance sheet) by
                              one-third or $3,333 and record the same amount of service-fee revenue on
                              the statement of operations (income statement). The same accounting
                              would occur at the end of the second and third accounting periods, so that
                              an equal portion of service revenue would have been recognized during
                              each period that the bank was obligated to loan the highly rated company
                              $100 million.8 Regarding disclosure of the $100 million commitment,
                              Commercial Bank A would not report the value of the loan commitment on
                              its balance sheet. However, the bank would disclose in the footnotes to its
                              financial statements the fair value of this commercial paper back-up facility
                              as well as the method used to estimate the fair value.9



Revenue Recognition for the   Although AICPA’s Audit and Accounting Guide, Brokers and Dealers in
Investment Bank               Securities does not provide explicit guidance for how Investment Bank B
                              would account for this specific transaction, the guide provides relevant
                              guidance on accounting for loan commitments in general. This guide states
                              that Investment Bank B would account for inventory, including financial
                              instruments such as a commercial paper back-up facility, at fair value and
                              report changes in the fair value of the loan commitment in earnings. When
                              changes occurred in the fair value of the loan commitment, Investment
                              Bank B would need to recognize these differences by adjusting the balance
                              of the deferred revenue account to equal the new fair value of the loan
                              commitment. Generally, quoted market prices of identical or similar
                              instruments, if available, are the best evidence of the fair value of financial
                              instruments. If quoted market prices are not available, as is often the case
                              with loan commitments, management’s best estimate of fair value may be
                              based on the quoted market price of an instrument with similar
                              characteristics; or it may be developed by using certain valuation
                              techniques such as estimated future cash flows using a discount rate


                              8
                               If the likelihood of exercising this commitment had not been remote, Commercial Bank A
                              would have followed the requirements of FAS 91, and not amortized the deferred revenue
                              until the commitment was exercised. Once exercised, the bank would recognize the fee
                              income over the life of the loan. If the commitment remained unexercised, income would be
                              recognized upon expiration of the commitment.
                              9
                              This is required by FAS No. 107, Disclosures about Fair Value of Financial Instruments.




                              Page 46                                                             GAO-04-3 Bank Tying
                            Appendix I

                            Differences in Accounting between

                            Commercial and Investment Banks for Loan 

                            Commitments





                            commensurate with the risk involved, option pricing models, or matrix
                            pricing models. A corresponding entry of identical value would be made to
                            revenue during the period in which the change in fair value occurred. Once
                            the commitment period ended, as described in the previous paragraph, the
                            deferred revenue account would be eliminated and the remaining balance
                            recorded as income.

                            If market conditions changed shortly after Investment Bank B issued this
                            credit facility and its fair value declined by 20 percent to $8,000, Investment
                            Bank B would reduce the deferred revenue account on its statement of
                            position (balance sheet) to $8,000, the new fair value. Investment Bank B
                            would recognize $2,000 of service-fee income, the amount of the change in
                            value from the last reporting period, in its statement of operations (income
                            statement). Investment Bank B would also disclose in its footnotes the fair
                            value of this credit facility, as well as the method used to estimate the fair
                            value.

                            If during the second accounting period there was another change in market
                            conditions and the value of this credit facility declined another 5 percent of
                            the original amount to $7,500, Investment Bank B would decrease the
                            balance in the deferred revenue account to $7,500 and recognize $500 in
                            service-fee revenue. Further, Investment Bank B would disclose in its
                            footnotes the fair value of this credit facility.

                            During the accounting period in which the commitment to lend $100
                            million was due to expire, accounting period 3 in this example, the balance
                            of the deferred revenue account would be recognized because the
                            commitment period had expired and the fair value would be zero. Thus,
                            $7,500 would be recognized in revenue and the balance of deferred revenue
                            account eliminated. In this accounting period, there would be no disclosure
                            about the fair value of the credit facility.



Differences in Revenue      The following table summarizes the amount of revenue Commercial Bank
Recognition Are Temporary   A and Investment Bank B would recognize and the balance of the deferred
                            revenue account for each of the three accounting periods when there were
                            changes in the value of the loan commitments. Commercial Bank A would
                            recognize more service-fee income in accounting periods 1 and 2 than
                            Investment Bank B. However, this situation would be reversed in period 3,
                            when Investment Bank B would recognize more revenue. Thus, differences
                            in the value of the loan commitment and the amount of revenue recognized
                            would likely exist between specific accounting periods, reflecting the



                            Page 47                                                      GAO-04-3 Bank Tying
                            Appendix I

                            Differences in Accounting between

                            Commercial and Investment Banks for Loan 

                            Commitments





                            volatility of the financial markets more transparently in Investment B’s
                            financial statements. The magnitude of the difference is determined by the
                            market conditions at the time and could be significant or minor. However,
                            these differences would be resolved by the end of the commitment period,
                            when both entities would have recognized the same amount of total
                            revenue for the loan commitment.



                            Table 1: Accounting Differences for a Loan Commitment

                                                     Commercial Bank A              Investment Bank B
                                                     Service-fee     Balance of     Service-fee    Balance of
                            Accounting                  revenue        deferred        revenue       deferred
                            period                   recognized        revenue      recognized       revenue
                            Initial recording of
                            the credit facility               $0         $10,000            $0        $10,000
                            1                              3,333           6,667         2,000          8,000
                            2                              3,333           3,334           500          7,500
                            3                              3,334              0          7,500              0
                            Total service-fee
                            revenue
                            recognized                   $10,000                       $10,000
                            Source: GAO.




Hypothetical Scenario       Commercial Bank A and Investment Bank B issued the same loan
                            commitment described previously. However, at the end of the second
for Exercised Loan          accounting period, the highly rated company exercised its right to borrow
Commitments                 the $100 million from each provider because its financial condition had
                            deteriorated and it could no longer access the commercial paper market.
                            The accounting treatment for this loan would depend upon whether bank
                            management had the intent and ability to hold the loan for the foreseeable
                            future or until maturity. AICPA Task Force members and some investment
                            bankers told us that in practice, this loan could be either held or sold, and
                            as a result, the accounting for both is summarized in the following sections.



Loans Intended to Be Held   At the time the loan was made, Commercial Bank A would record the $100
to Maturity	                million dollar loan as an asset on its statement of position (balance sheet).
                            Investment Bank B would initially record this loan at its historical cost
                            basis, less the loan commitment’s fair value at the time the loan was drawn



                            Page 48                                                        GAO-04-3 Bank Tying
Appendix I

Differences in Accounting between

Commercial and Investment Banks for Loan 

Commitments





($100 million - $7,500). Further, based on an analysis by the banks’ loan
review teams, a determination of “impairment” would be made. According
to FAS 114, Accounting by Creditors for Impairment of a Loan, “a loan is
impaired when, based on current information and events, it is probable that
a creditor will be unable to collect all amounts due according to the
contractual terms of the loan agreement.” If the loan were determined to be
impaired, FAS 114 states that, the bank would measure the amount of
impairment as either the (1) present value of expected future cash flows
discounted at the loan’s effective interest rate, (2) loan’s observable market
price, or (3) fair value of the collateral if the loan were collateral
dependent.

FAS 114 directs both banks to establish an allowance for losses when the
measure of the impaired loan is less than the recorded investment in the
loan (including accrued interest, net of deferred loan fees or costs and
unamortized premium or discount) by creating a valuation allowance that
reduces the recorded value of the loan with a corresponding charge to bad-
debt expense. When there are significant changes in the amount or timing
of the expected future cash flows from this loan, the banks would need to
adjust, up or down, the loan-loss allowance as appropriate so that the net
balance of the loan reflects management’s best estimate of the loan’s cash
flows. However, the net value of the loan cannot exceed the recorded
investment in the loan.

If the loan were not impaired, both banks would still record an allowance
for credit losses in accordance with FAS 5, Accounting for Contingencies,
when it was probable that a future event would likely occur that would
cause a loss and the amount of the loss was estimable.10 Thus, both banks
would establish an allowance for loss in line with historical performance
for borrowers of this type.11 Because the loan was performing, both banks
would receive identical monthly payments of principal and interest.
Generally, these cash receipts would be applied in accordance with the


10
   On June 19, 2003, AICPA issued an exposure draft of a proposed statement of position for
allowance for credit losses. This exposure draft proposes various revisions to how banks
would estimate credit losses and report them on their financial statements and is proposed
to be implemented after December 15, 2003.
11
   FAS 5 states that receivables by their nature usually involve some degree of uncertainty
about their collectibility, in which case a loss contingency exists. If a loss were not probable
and estimable, both banks would disclose in their financial statement footnotes, the loss
contingency when there was at least a reasonable possibility that a loss or additional loss
might be incurred.




Page 49                                                                   GAO-04-3 Bank Tying
                           Appendix I

                           Differences in Accounting between

                           Commercial and Investment Banks for Loan 

                           Commitments





                           loan terms, and a portion would be recorded as interest income; and the
                           balance applied would reduce the banks’ investment in the loan. At the end
                           of the loan term, the balance and the related allowance for this loan would
                           be eliminated.

                           FAS 91 also directs both banks to recognize the remaining unamortized
                           commitment fee over the life of the loan as an adjustment to interest
                           income. Because the borrower’s financial condition had deteriorated, both
                           banks would likely have charged a higher interest rate than the rate stated
                           in the loan commitment. As a result, at the time it becomes evident that the
                           loan is to be drawn, Investment Bank B would record a liability on its
                           balance sheet to recognize the difference between the actual interest rate
                           of the loan and the interest rate at which a loan to a borrower with this
                           level of risk would have been made—in essence the fair value interest rate.
                           This liability would also be amortized by Investment Bank B over the life of
                           the loan as an adjustment to interest income.



Loans Made Available for   If Commercial Bank A and Investment Bank B’s policies both permitted the
Sale                       firms to only hold loans for the foreseeable future or until maturity when
                           the borrowers were highly rated, it is unlikely that the banks would keep
                           the loan in the previous hypothetical scenario and would sell the loan soon
                           after it was made.12 Although the banks would follow different guidance
                           there would be similar results. Commercial Bank A would follow the
                           guidance in the AICPA Statement of Position 01-6.13 According to this
                           guidance, once bank management decides to sell a loan that had not been
                           previously classified as held-for-sale, the loan’s value should be adjusted to
                           the lower of historical cost or fair value, and any amount by which
                           historical cost exceeds fair value should be accounted for as a valuation
                           allowance. Further, as long a the loan’s fair value remained less than
                           historical cost, any subsequent changes in the loan’s fair value would be




                           12
                            In order to keep this exception scenario example simple, it is also assumed that there are
                           not conditions that would constrain Commercial Bank A and Investment Bank B from
                           selling the loan, that both banks will not retain any interest in the loans sold, and the loans
                           are sold without recourse.
                           13
                             Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend
                           to or Finance the Activities of Others, December, 2001.




                           Page 50                                                                   GAO-04-3 Bank Tying
Appendix I

Differences in Accounting between

Commercial and Investment Banks for Loan 

Commitments





recognized in other comprehensive income.14 Investment Bank B would
follow the guidance in the AICPA’s Audit and Accounting Guide, Brokers
and Dealers in Securities, as it did with loan commitments, and account
for inventory at fair value and report changes in the fair value of the loan in
net income.

For example, if bank management decided to sell the loan soon after it was
drawn when some payments had been made to reduce the principal
balance and the net book value of this loan was $88,200,000 (unpaid
principal balance of $90,000,000 less the related allowance of $1,800,000)
and the fair value was 97 percent of the unpaid principal balance or
$87,300,000, both banks would recognize the decline in value of $900,000 in
earnings. While the loan remained available-for-sale, any changes in its fair
value would be recorded in net income. For example, if the loan’s fair value
declined further to $85,500,000, both banks would recognize the additional
decline in value of $1,800,000 in earnings.

Table 2 below summarizes the accounting similarities between Commercial
Bank A and Investment Bank B for the loan sale. Although the two banks
followed different guidance, the effect of the loan sale is the same for both
banks.



Table 2: Accounting Differences for a Loan Sale

                                 Commercial Bank A loss          Investment Bank B loss
Transaction                                    amount                          amount
Transfer the loan to the
trading portfolio                               <$900,000>                    <$900,000>
Change in fair value                          <$1,800,000>                  <$1,800,000>
Total loss on loan sale                       <$2,700,000>                  <$2,700,000>
Source: GAO.




14
   Comprehensive income is defined in FAS 130, Reporting Comprehensive Income, as the
change in equity [net assets] of a business during a period from transactions and other
events and circumstances from nonowner sources. It includes all changes in equity during a
period except those resulting from investments by owners and distributions to owners.




Page 51                                                              GAO-04-3 Bank Tying
Appendix II

Comments from the Federal Reserve System





              Page 52              GAO-04-3 Bank Tying
Appendix II

Comments from the Federal Reserve System





Page 53                                     GAO-04-3 Bank Tying
Appendix III

Comments from the Office of the Comptroller
of the Currency




               Page 54              GAO-04-3 Bank Tying
Appendix III

Comments from the Office of the Comptroller 

of the Currency





Page 55                                         GAO-04-3 Bank Tying
Appendix IV

GAO Contacts and Staff Acknowledgments




GAO Contacts	      Richard Hillman, (202) 512-8678
                   James McDermott, (202) 512-5373



Acknowledgments	   In addition to those individuals named above, Daniel Blair,
                   Tonita W. Gillich, Gretchen Pattison, Robert Pollard, Paul Thompson, and
                   John Treanor made key contributions to this report.




(250099)           Page 56                                                 GAO-04-3 Bank Tying
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